Max pain, or the max pain price, refers to the strike price with the most open options contracts (i.e., puts and calls), and it is the price at which the stock would cause financial losses for the largest number of option holders at expiration.
The term max pain stems from the maximum pain theory, which states that most traders who buy and hold options contracts until expiration will lose money.
Key takeaways:
Max pain, or the max pain price, is the strike price with the most open contract puts and calls and the price at which the stock would cause financial losses for the largest number of option holders at expiration.
The Maximum Pain theory states that an option's price will gravitate towards a max pain price, in some cases equal to the strike price for an option, that causes the maximum number of options to expire worthless.
Max pain calculation involves the summation of the dollar values of outstanding put and call options for each in-the-money strike price.
Understanding Max Pain
According to the maximum pain theory, the price of a underlying stock will often gravitate towards its "max pain strike price" - the price at which the largest number (measured by dollar value) of options will expire worthless.
The theory assumes that options sellers will hedge their written contracts. For market makers, hedging is done to maintain neutrality on the stock. This is done since the market maker may be required to write an option contract but does not want to hold the stock.
As options expiration approaches, option sellers will attempt to buy or sell the stock to push the price towards a closing price that is beneficial to them or at least to pay a hedge that rewards the option holders. For instance, a call option seller hopes the stock price will drop, while a put option seller hopes the stock price will rise.
Approximately 60% of options are traded away, 30% become worthless options at expiration, and 10% are exercised. The max pain is the point at which option holders (buyers) feel the "maximum pain," or the point at which they would face the biggest loss. However, option sellers may stand to gain the most.
The maximum pain theory is highly controversial. Critics of the theory are divided into two camps, one believing that the tendency of a stock price to gravitate towards the max pain strike price is coincidental, while others view it as a form of market manipulation.