Can Maximum Pain Theory Predict Future Price Movements?
Options have become a popular trading instrument for investors to leverage assets and mitigate risks associated with playing the market. With options, it’s possible to profit whichever direction the market is going. While many options traders profit from buying and selling, options writers have a lot to gain from contracts expiring worthless.
Don’t know what options are? Read this first.
Disclaimer: This article is simply for educational purposes. I’m not a financial expert, and you should always trade at your own risk.
What is the Maximum Pain Theory?
As the expiration date approaches, options ‘tend’ to gravitate towards a strike price where most open puts and calls expire worthless. This is known as max pain or the max pain price. The price where option buyers feel “maximum pain,” or will lose the most money and option writers profit.
How is the price manipulated?
The theory states that option writers will hedge the contracts they have written by driving the price towards a closing price that is profitable for them. Call writers will sell shares to drive the price down and put writers will purchase shares to drive the price up.
How is Max Pain calculated?
The max pain price is calculated by summing the cash value (intrinsic value) of each put and call options contract at each of the different strike prices and finding the strike price with the lowest cash value.
Set each strike price as the ‘expiration price’. Then for each closing price:
- Find the difference between each strike price and the ‘expiration price’
- Multiply the result by the open interest at that strike
- Add the dollar values for the put and call at that strike
- Repeat for each strike price
Let’s take a look at the July 31st Bitcoin call options on Deribit.
For the purpose of this article, we will only calculate the cash value for the first few contracts for the 5000 strike price.
We use the formula below to calculate the cash value of each contract.
ABS(Expiration Price - Strike Price) × Open Interest
Expiration price: 5000
- Strike Price: 5000, Open Interest: 31.70
abs(5000 - 5000) × 31.70 = $0 (options that expire at-the-money are worthless)
2. Strike Price: 5500, Open Interest: 30.00
abs(5000 - 5500) × 30.00 = $15,000
3. Strike Price: 6000, Open Interest: 42.90
abs(5000 - 6000) × 42.90 = $42,900
…and so on
Once you’ve calculated the cash value of each contract for the 5000 strike price, you will continue to the next strike price of 5500, 6000, 6500, etc. and repeat this process. You will need to do this for the put side as well and finally sum the cash values for both puts and calls at each strike price. You can then plot this data on a graph.
Too lazy to do this yourself? Visit CoinOptionsTrack to view all the max pain values for each expiration date.
Below is a graph representing the total cash value for each option expiring on July 31.
The red markers indicate the total cash value that would be paid out to option writers on all calls and puts at each strike price. The max pain price is indicated by the lowest point on the graph. In this case, the max pain price is $9500.
Does Max-Pain Work?
Let’s take a look at an example:
The June 26 option contracts made up 69% of the total open interest on Deribit. As of June 25, the graph of the total cash value for each option looked like this:
The $9250 strike price had the lowest cash value out of all of the strike prices, therefore, $9250 is the max pain price. On June 26, the price of BTC settled at $9,115.84, slightly lower than the max pain price. It is important to note that cryptocurrency trading occurs 24 hours a day, and the max pain price can change on an hour-by-hour basis.
Conclusion
The Max Pain Theory isn’t a trading strategy that can be relied on consistently, however, it does give us a rough idea of where the price will be on expiration.
To increase the probability of success, the max pain theory can be used in tandem with Open Interest walls or OI walls — the highest put open interest strike and highest call open interest strike. They can be used to indicate key support and resistance levels. OI walls provide a higher probability of success since they imply the closing price will be between two strike prices instead of an exact closing price.
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