Maximum Pain Trading Theory, Explained

2 mins read

 

This originally appeared on Benzinga.

Trading options is a great way for investors to supplement their stock portfolio returns, hedge against unexpected market downturns or generate leverage for potential high-return trading ideas.

The options market can also be a useful source of information for stock traders.

One stock trading strategy revolves around the idea that high-powered option sellers will always look to push a stock’s share price toward an optimal price on option expiration dates.

Point Of Maximum Pain: Small retail option traders typically buy and sell a handful of option contracts at a time, but large institutional investment firms can generate returns by writing call and put option contracts and profiting from the premiums buyers pay. Option contract writers maximize their profits when the contracts they sell expire out-of-the-money, allowing them to keep 100% of the premiums they collected.

Call writers want an underlying stock’s price to fall below the contract’s strike price, while put writers want the stock’s price to rise above the contract’s strike price.

However, there is exactly one price at which both call options and put options expire worthless — the strike price itself.

A wide range of call and put strike prices for a particular stock on any given expiration date exist, but typically just a handful of strike prices have particularly large open interest for both call and put contracts.

The strike price with the most open contracts is the price at which the stock would produce the largest losses for option buyers, so this price is often referred to as the “maximum pain” price.

Maximum Pain Trading: As an expiration date approaches, it’s in the option writer’s best interest to do at least one of two things. First, they can buy or sell shares of the underlying stock in an attempt to drive the stock price toward the max pain price. In addition, they can hedge their long or short exposure, which essentially creates the same effect of pushing the stock price toward the max pain price.

Call writers sell shares of the underlying stock when it is trading above the max pain price, and put writers buy shares of stock when it is trading below the max pain price. All of this aggregate buying and selling effectively “funnels” the stock’s share price toward the max pain price as expiration nears.

This effect is sometimes called “pinning” or “pinning the strike.” Traders often say a stock that ends an option expiration date with a closing price at or extremely close to a popular option strike price has been pinned.

How To Play It: Many popular online sources tell traders the max pain price for a particular stock on a particular options expiration date. Once traders know the max pain price for that date, they can buy the stock throughout the day when it’s below that strike price and sell it when it’s above it.

Of course, like every trading strategy in the market, max pain pinning is more of a tendency than a hard rule. However, knowing and understanding the price of maximum losses for option buyers can be a useful guide in the closing minutes of trading on an option expiration date.

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