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Calculate Max Pain

Max Pain Theory

The origins of Option Pain dates back to 2004. So, in a sense, this is still a very young theory. As far as I know there are no academic/scholastic papers on it, which makes one wonder why the academia has ignored this concept.

The theory of options pain stems as a corollary to the belief – “90% of the options expire worthless, hence option writers/sellers tend to make money more often, more consistently than the option buyers”.

Now if this statement is true, then we can make a bunch of logical deductions –

  1. At any point only one party can make money i.e either the option buyers or option sellers, but not both. From the above statement, it is clear that the sellers are the ones making money.
  2. If option sellers tend to make maximum money, then it also means that the price of the option on expiry day should be driven to a point where it would cause least amount of loss to option writers.
  3. If point 2 is true, then it further implies that option prices can be manipulated, at least on the day of expiry.
  4. If point 3 is true, then it further implies that there exists a group of traders who can manipulate the option prices, at least on the day of expiry.
  5. If such a group exists then it must be the option writers/sellers since it is believed that they are the ones who make maximum money/consistently make money trading options.

Now considering all the above points, there must exist a single price point at which, if the market expires, then it would cause least amount of pain to the option writers (or cause maximum amount of pain to option buyers).

If one can identify this price point, then it’s most likely that this is the point at which markets will expire. The ‘Option Pain’ theory does just this – identify the price at which the market is likely to expire considering least amount of pain is caused to option writers.

Here is how formally defines Option Pain – “In the options market, wealth transfer between option buyers and sellers is a zero sum game. On option expiration days, the underlying stock price often moves toward a point that brings maximum loss to option buyers. This specific price, calculated based on all outstanding options in the markets, is called Option Pain. Option Pain is a proxy for the stock price manipulation target by the option selling group”.

Credit to varsity for explaination.

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Max-Pain calculator allows user to calcualte max pain based on trading symbol of NIFTY and expiry