Options Max Pain, also known as "Max Pain Theory," is a hypothesis in options trading that suggests the price of an underlying asset will gravitate toward a specific price, referred to as the "max pain" price, where the largest number of options contracts would expire worthless. This would cause the greatest financial "pain" to the options holders.

How Does Max Pain Work?

The Max Pain Theory proposes that the price of the underlying asset is influenced by the collective actions of options market participants. These participants might push the price towards the max pain price to maximize their own profits. For instance, if a large number of call options are purchased at a certain strike price, the holders of these options may attempt to buy the underlying asset to push its price up to that strike price.

Calculating Max Pain

The max pain price can be calculated as follows for options with a given expiration date:

• Find the intrinsic value (difference between stock price and strike price) for calls and puts at each strike.
• For each strike, multiply the intrinsic value as calculated above by the open interest for both calls and puts.
• Sum the dollar value of calls and puts by strike.

The strike price with the highest value from the above calculations is the max pain price for that expiration.

Why Monitor Max Pain?

Some traders use Max Pain as one factor in their analysis, often combined with other indicators. Max Pain can help understand the sentiment of other market participants, and thus be used to gauge market sentiment.

Limitations of Max Pain

The Max Pain Theory is controversial and has not been proven to be consistently accurate. The price of the underlying asset is influenced by numerous factors beyond options trading, such as supply and demand, economic conditions, and market sentiment. Furthermore, options prices are determined by various factors, including the underlying asset price, expiration dates, and implied volatility, making it challenging to rely solely on the max pain price for trading decisions.