13.1 - My experience using Option Pain Theory

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.

13.2 - Max Pain Theory

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.

1. Only one party can make any money at any given moment, i.e. the option buyers or the option sellers. But not both. It is evident that the sellers make the most money from the statements above.
2. Option sellers are more likely to make the most money. This means that the expiry date price should be set so that option writers suffer the least loss.
3. If point 2 is true then it implies that option prices could be manipulated at most on the expiry date.
4.    If point 3 is true,  it means a group of traders are there who atleast on the expiry day  can manipulate the prices of option 
5. It is likely that such a group exists. They are believed to be option writers/sellers, as they are those who consistently make the most money from trading options.

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.

13.3 - Max Pain Calculation

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.
(chart).
 

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

= Rs.4,382,277,500/-

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.

(chart).
 

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.
(image 1)
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.
(image 2
 

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.

1. Every day, the OI values are changing. The option pain may suggest 7800 for 10 th May, and 8000 for 20 _ th May. To run the computation, I stopped on a specific day of the month. This was the best way to do it when there were only 15 days left.
2. I determined the expiry value using the regular option pain method.
3. I would also add a 5% safety buffer. If 7800 is the expiry date, which would be 15 days, I'd add a safety buffer of 5%. This would give the expiry value of 7800 + 5% from 7800 = 8190, or 8200 strike.
4. I expect the market will end at any time between 7800 and 8200.
5. This expiry range would be a key factor in my strategies. My favorite is to create call options that exceed 8200.
6. For this simple belief, panic spreads quicker than greed and I wouldn't recommend writing Put option. This means that markets can plummet faster than they can rise.
7. I would keep the options until expiry and avoid averaging during that period.

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.
(image 3)
 

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:

• If the PCR value exceeds 1, it could be 1.3. This indicates that more Calls are being purchased than Puts. This indicates that the market has turned very bearish and is therefore oversold. You can expect market reversals.
• Low PCR values, such as 0.5 or below, indicate that more calls are being bought than put. This indicates that the market has become extremely bullish and is therefore overbought. You can expect the markets will fall if you look for market reversals.
• Any value between 0.5 to 1 can be attributed regularly trading activity, and cannot be ignored.

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.

13.6 - Final thoughts

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!

Key takeaways from this chapter

1. Option Pain theory holds that option writers make more money per year than option buyers.
2. Option pain is the assumption that option writers can influence price on expiry day.
3. To determine the likely expiry price of a stock/index, one can use the theory o f option pain.
4. The strike at the expiration of the stock/index is the one at which option writers would suffer the least loss.
5. Calculating the PCR involves dividing the total open interests of Puts by those of Calls.
6. The PCR is considered a contrarian indicator.
7. A PCR value greater than 1.3 is generally considered bearish, while a value less than 0.5 can be considered bullish.