The theory of "Option Pain" is one of the most controversial theories in the market. Option Pain, sometimes called 'Max Pain', has a large fan base and probably an equal number who hate it. Let me be transparent, I have been in both! I wasn't able to make consistent money in the first days of Option Pain. Over time, I discovered ways to adapt this theory to my risk appetite and got a decent result.In the next chapter we will discuss it.
Now, I'm going to try to explain the Option Pain theory to you and tell you what I think about Max Pain. This chapter can help you decide which camp to join.
Option Pain theory demands that you are familiar with the conceptof open interest.
So, let's get started.
Option Pain was first developed in 2004. This theory is still very new. It is not covered in academic/scholastic papers, so it is hard to understand why academia has neglected this idea.
As a corollary of this belief, the theory of options pain is that "90%" of the options are worthless. Therefore, option sellers/writers make more money than option buyers more often and more consistently.
If this statement is true, we can then make many logical deductions.
Now, take into account all of the points above.there must be a single price existence to which,even if the market expires it can cause low amount of pain to the writers(or cause more pain to option buyer)
This price point is most likely to be the expiration point for markets if it can be identified. This is what the 'Option Pain Theory' does - it identifies the price at which markets are likely to end, taking into account the least amount of pain that is caused by option writers.
Optionspain.com defines Option Pain as "In the options marketplace, wealth transfer between buyers and sellers is an infinitesimal game." The underlying stock price moves towards a point where option buyers are at maximum risk on expiration days. Option Pain is the name of this price. It is calculated using all available options in the markets. Option Pain is an indicator of the target stock price manipulation by the option selling groups.
This is a step-by-step guide on how to calculate Max Pain. This may seem confusing at first, but it is worth reading. It will become clearer when we look at an example.
Step 1 List the strikes and take note of the open interest for both calls and puts.
Step 2 Assume that the market ends at the strike price you have indicated.
Step 3 Calculate the amount of money that option writers (both call and put) lose if the market closes according to the assumption in step 2.
Step 4 Add up the money you have lost to call and put option writers.
Step 5: Identify the strike at the lowest amount of money that option writers have lost.
Option buyers suffer maximum pain at this level. This is the lowest amount of money option writers can lose. This is also the price at which it is most likely that the market will end.
To understand this, let's use a simple example. Assuming there are 3 Nifty strikes on the market, this is the best example. I've taken note of the open interest in the call and put options for each strike.
Scenario 1: Assume that markets end at 7700
You will only lose money if the market moves higher than the strike price when you write a call option. The same applies to Put options. You will only lose money if the market moves below the strike price.
The market will expire at 7700. Therefore, no call option writer will lose any money. Call option writers at 7700, 7800 and 7900 strikes will keep the premiums they received.
The put option writers, however, will have trouble. Let's begin with the 7900 PE writers.
7900 PE writers would lose 200 point at 7700 expiry. The Rupee loss value would be -, as the OI stands at 2559375.
= 200 * 2559375 = R. 5,11,875,000/
7800 PE writers would lose 100 point, the Rupee value will be
= 100 * 4864125 = Rs.4,864,125,000/=
7700 PE writers won't lose any money.
The combined loss of option writers and market participants if the markets close at 7700 is -
Total money lost to Call Option writers + Total Money lost to Put Option writers
= 0 + R.511875000 + 4.864125000 = HTML9,982,287,500/
Remember that Call Option writers lose total money = money lost to 7700 CE writers + money lost to 7800 CE + money loss by 7900 CE
The Total Money Loss by Put Option Writers = money lost to 7700 PE writers + money lost to 7800 PE + money loss by 7900 PE
Scenario 2: Assume that markets end at 7800
The following call option writers would lose their money at 7800
7700 CE writers would lose 100 point, and multiply that Open Interest by the Rupee loss.
100*1823400 = Rs.1,823,340,000/-
Both 7800 CE and 7900 CE sellers would make money.
The 7700 PE seller would not lose money
The 7900 PE would lose 100 point, and if we multiply that with the Open Interest, the Rupee loss is calculated.
100 * 2559375 = Rs. 2,55,937 7,500/-
The combined loss of Options writers at 7800 market would be -
= 182340000 + 255937500
Scenario 3: Assume that markets end at 7900
The following call option writers would lose their money at 7900
7700 CE writer would lose 200 point, Rupee value would be -
200 *1823400 = Rs. 3,646,800,000.00/-
7800 CE writer would lose 100 point, the Rupee value for this loss would be -
100*3448575 = Rs. 3,44,857 5,500/-
7900 CE writers would keep the premiums received.
Market expires at 7900 so all put option writers would keep the premiums they received.
Therefore, the total loss of option writers combined would be -
= 3646800000 +344857500 = Rs. 7,095,375,000 /-
At this point, we have calculated the Rupee loss for option writers at each possible expiry level. Let me do the same for your benefit.
We now know the total loss that option writers would suffer at each expiry level. This allows us to identify when the market will expire.
According to the option pain theory, market will end at the point of least pain (read it like the least loss). Option sellers.
This table clearly shows that 7800 is the point where the combined loss is 438277500, or approximately 43.82 Crores. This is much less than the combined loss of 7700 and 7900.
It's very easy to calculate. To simplify the calculation, I have only used 3 strikes. In reality, there are many ways to strike an underlying, Nifty being the most common. Calculations can become confusing and cumbersome, so one might need to use a tool such as excel.
The option pain value as of today (10 th May 2016), was calculated using excel. Take a look at this image.
We assume that market will expire at this point, and then calculate the Rupee loss for CE or PE option writers. This value is displayed in the "Total Value" column. After calculating the total value, it is time to find the lowest amount of money lost by an option writer. This can be identified by plotting the "bar graph" of the total value. This is the bar graph.
As you can see the 7800 strike represents the point at which option authors would lose the most money. According to the option pain theory 7800 is the likely market expiration date for the May series.
How can you use the expiry level information you have now established? There are many ways to use this information.
To identify the strike they can write, most traders use this maximum pain level. This means that 7800 is the expected expiry threshold. One can write call options over 7800 or put options under 7800 to collect all premiums.
13.4: A Few Modifications
I was eager to learn more about Option Pain in the first days. It made perfect sense. I can still remember crunching numbers and identifying the expiry point. Then, I wrote options to my glory. Surprisingly, the market would end at another point. I had to book a loss. I wondered if my calculations were wrong or if the whole theory was flawed.
So, I finally improvised the classic option pain theory to fit my risk appetite. This is what I did.
This method produced better results. I have not been able to quantify my gains because I didn't tabulate the results. If you have a programming background, it is possible to back-test this logic and share the results here. However, I discovered that the 5% buffer was actually taking to strikes, which were about 1.5 to 2% standard deviations from the target expiry level.
This chapter on standard deviation, distribution of returns will help you understand what it means.
You can Download The Option Pain Calculation Excel.
13.5 – The Put Call Ratio
It is easy to calculate the Put Call Ratio. This ratio is used to identify extreme bearishness or bullishness in the market. The PCR is often considered a contrarian indicator. If PCR is extremely bearish, traders should expect that the market will reverse and the trader becomes bullish. If PCR is extreme bullish, traders can expect markets to decline and reverse.
Simply divide the total open interests of Calls and Puts to calculate PCR. The result is usually around one. Take a look at this image.
The total OI for both Calls and PUTs was calculated as of 10 th May. Divide the Put OI by the Call OI to get the PCR ratio.
37016925/ 42874200 = 1.863385
This is the meaning:
This is an illustrative approach to PCR. It would make more sense to historical plot daily PCR values over a period of, say, 1 or 2 years in order to identify extreme values. A Nifty value of 1.3 could indicate extreme bearishness while Infy values of 1.2 or 1.3 could indicate extreme bearishness. This is why back testing can be very helpful.
It is possible to wonder why the PCR is used for contrarian indicators. The explanation is a bit complicated, but it is generally believed that PCR is used as a contrarian indicator. The position will end up being squared, which would cause the stock/index to move in the opposite direction.
This is PCR. There are many variations of this. Some prefer OI to the total traded value, while others prefer volumes. However, I don't believe it is necessary to over-think PCR.
This concludes the module on Options. It has been divided into 2 modules and 36 chapters.
This module has covered close to 15 options strategies. I believe this is enough for retail traders to be able to trade professionally. You will be able to encounter many fancy options strategies. Your friend might suggest one and then show you the technicalities. But remember, 'fancy doesn't translate into profit. Simple, elegant, and simple strategies are the best.
Both Module 5 and Module 6 contain content that aims to give you an overview of options trading. It will show you what options trading can do and what it cannot. We've discussed and thought about what is necessary and what isn’t. These two modules will answer all your questions/concerns about options.
Please take the time to review the content and then start trading the right way.
Finally, I hope that you enjoy this article as much as I enjoyed writing it.
Stay profitable and good luck!