Max Pain
What is maximum pain? Stock option contracts are two sided contracts. The option
buyer is the person paying a premium in exchange for the right to buy or sell a
stock at a future date, the option expiration. The option writer collects the
premium, but then is ultimately responsible to fulfill the option contract should
it get exercised.
For example, imagine a call option for stock XYZ. The option buyer agrees to
pay a certain price, the premium for the right to purchase 100 shares of stock
XYZ at option expiration. The option writer collects the premium, but is then
obligated to sell 100 shares of XYZ stock at the option strike price.
Further imagine a market maker writing 10 call option contracts at 120 strike price in
order to statisfy demand. The market maker then buys 10 call option contracts at 110
strike which partially hedges the calls he has written. However, he must now hedge
the 10 call options. This is accomplished creating a stock position opposite that of the
option delta. In this case of call options, the market maker establishes a short
position in stock XYz.
As option expiration approaches, stock XYZ rises in price. In order to remain neutral,
the market maker must rebalance his hedge. Since the stock has increased, the call option
increased and he must sell additional stock to maintain the short position. This causes
the stock price to fall.
Conversely, if the stock price fell, then the call options may be out of the money and
worthless. The market maker no longer needs the short position to hedge the calls. He
buys XYZ stock to close his short position, thus driving the stock price up.
The collective effect of the rebalancing by multiple market makers and traders known as "pinning" drives the stock prices
toward a specific strike. Furthermore, the rebalancing pressure is greatest toward the
strike with the least amount of money at risk for the option writers. For the option
buyers, this strike results in the maximum amount of premium loss, hence the term "max pain".
In conclusion, there are market forces that drive the stock price toward the point of max
pain. Weekly options were introduced in 2010. Every Friday there is a option expiration. BY calculating the weekly max pain point, you learn the what the closing price on Friday will
be. You then make trades accordingly.
See the weekly AAPL maximum pain calculation.