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What is Option Pain and how can it used in practice

07 Sep 2023

If you are an investor and have been in the stock market for some time, you may have heard of certain theories such as option greeks, the max pain theory and implied volatility fluctuation, among others. What are these, you may ask? For instance, what is max in options? Before you get into more details, you should know that theories in the market may come as news to you as these are relatively new, just as the concept of options is in the market itself. If you consider how old the stock market is, all these concepts are “fresh”, but they are not challenging to grasp. In practice, traders have to be prepared with a specific appetite for risk to be able to execute some option theories. Having said that, some theories work with some traders, while others are more suited to different traders. The first thing to be clear about is the concept of options trading itself. Then, you can learn about max pain and decide whether you are suited to it in your options trading activity. 

Trading Options - Some Basics

You may have heard of futures and options and may even know what these are. In options trading, a contract to buy or sell stocks is entered. One party agrees to buy the stocks, and the other agrees to sell. Whichever side of the contract the investor is on, either agreeing to buy or to sell, the investor has the right to buy or sell stocks in a particular number, by a certain date. Here, the right to buy or sell is stipulated, and there is no obligation to do so on either party’s part. In options trading, either stock can be agreed to be bought or sold, or an index could be agreed to be bought or sold. Therefore, in terms of the theory of max pain, there could be a max pain Bank Nifty strategy that an options trader may be willing to undertake. 

What is option pain?

A fairly common usage, albeit controversial is the concept Option Pain. Before we get into the concept of Option Pain, let us look at the logic behind this concept of Option Pain. In most F&O markets, especially in India, the retail traders are typically option buyers. On the other hand, option selling is done by large institutions, proprietary desks of brokers, HNIs etc. It is assumed that since option sellers are much better informed decisions, they are able to write options in such a way that most of the options expire worthless. For example, when buy calls and puts, all OTM options and ITM options will expire worthless. But then what is OTM for the call will be ITM for the put and what is OTM for the put will be ITM for the call. That is where the point of Maximum Option Pain comes in. Option Pain is the point or the strike price where the largest number of options open interest will expire worthless. In other words, Max Option Pain is the strike where the combined open interest of calls and puts is the highest.

Understanding Option Pain with Bank Nifty

Data source: NSE

The above chart captures the Option Chain data of the Bank Nifty for the November Contract that expires on 29th November. If you look at the yellow shaded portion, it is at a stroke of 26,000 that there is the maximum combined allocation of calls and puts. While individually there may be strikes with higher OI accumulation, it is this strike of 26,000 that is seeing the maximum combined OI accumulation. That level is called the Max Pain Point of the option. Of course, these options OI data is subject to constant change and hence needs to be calculated on a real time basis. Prima facie, this means that the option expiry for the Bank Nifty will converge towards the level of 26,000. Quite often, this number in isolation may not mean much but if you track the Max pain data real time, then you get a fairly good picture of whether the price at the time of expiry will trend down or up. This is not scientifically backed but it has surely been empirically tested.

Can traders actually rely on the Max Pain theory?

Broadly, it is true that option sellers have a better understanding and therefore better control over option prices compare to the retail traders who are essentially buyers of the options. That means you can take advantage of the max pain theory. The theory believes that as options expiration approaches, stock price will get pushed toward the price at which the greatest number of options (in terms of rupee value) will expire worthless. In other words, the theory holds that when expiration approaches, stock or index price will gravitate toward the price that will cause maximum pain to both call and put buyers. In short, option pain is the point at which buyers lose the most and sellers gain the most. If you understand this concept, then even as an option buyer, you can profit from this knowledge.


How option buyers can profitably apply the Max Option Pain idea?

The broad assumption with the Max Pain theory is that the expiry price will gravitate towards the price at which there is maximum pain for buyers of options.

Where the Max Pain point is sharply lower or higher than the current market spot price, the trader can look to either sell or buy the futures to profit from the trade. In the above case of Bank Nifty, the spot value is at 26,300 and the Max pain point is at 26,000. The trader can look to sell Bank Nifty Futures accordingly.

Traders can also use this Max Pain point to either book profits or cut losses on options position, depending on which side the trade is positioned. In the above case of Bank Nifty, if you are holding on to a 26,200 call option then waiting till expiry will mean gaining nothing. Currently, if you are getting the intrinsic value of Rs.100 plus a small time value, then it makes sense to monetize the profits. You can also look to play this trend by buying put options that are slightly out of the money.

There are two key things to remember while using the Option Pain theory. Firstly, option pain has been empirically tested although there is no confirmation of the existence of such a specific theory. Hence you must use this Option Pain theory in conjunction with other fundamental and technical indicators. Secondly, the Max Pain theory will gradually lose its sheen and utility if too many traders start applying it. That is a risk you need to be conscious of.

 

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