Max Pain option strategy provides valuable data concerning future stock prices. Market forces tend to drive the stock price toward the Max Pain point at the stock market close on option expiration dates. With the introduction of weekly options in addition to monthly options, this means we have an idea of where the stock price will close every Friday. For example, Apple stock trades weekly options. Using this stock option strategy, you can tell where the Apple stock price will be every Friday at the close.
For either call or put stock options, there is an option buyer and an option writer. Max Pain basically means the point at where the most open option contracts expire out of the money, thus “pain” in terms of lost premium for the option buyers. The converse of that is it is the point for least cash paid by the option writers. Option writers are generally large players like market makers. These larger players hedge against the option contracts they write. This hedge rebalancing is a major factor in the contributing market forces that drive the stock price toward the point of Max Pain.
There are two primary means of determining the Max Pain point. The first and most accurate method is the cash value method. Here, the cash value of all open contracts is calculated. Cash value is the difference between the strike and stock price multiplied by the open interest at the strike multiplied by 100 shares per option contract. By calculating the total cash value of all call and put options for various closing stock prices, you can determine which closing price has the lowest total cash value. This is the Max Pain point.
The second method is to simply look at the number of combined open put and call contracts. The highest combine open interest is assumed to be the max pain point. This method is inaccurate, however, some people use it because any option data sources (the CBOE or yahoo Finance) supplies open interest data. You do not need to perform any calculation other than adding the call and put open interest. Therefore, it is quick and easy. Finding the highest combined put and call open interest gives you a general notion of where the stock will close. The cash value method is more accurate and there are free online calculators doing the work for you.
You can make short term investment decisions using this stock option strategy. If the stock is below this point, you know there will be significant pressure of the stock to rise but option expiration. You could buy the stock outright or by call options. Conversely, if the stock is above this point, you can short it or buy put options. You should buy longer term monthly expiration options, and then trade them as if they were weekly options. The theta on the weekly options causes the premium to decay very rapidly.