By: Steve Smith
There is all kinds of pain in this world, which typically falls under the physical, mental or financial category. And then there are options — so excruciating it has its own definition in option education material.
The concept of max pain is tied to expiration days. Today happens to be the last quarterly, or triple witching expiration of 2020. To that, I say good riddance! The max pain concept attempts to find the strike prices with the most open interest in both puts and calls where the stock would cause financial losses for the largest number of option holders at expiration.
The respective theory states that most traders who buy and hold options until expiration will lose money. Below, is the basic formula for calculating it:
For each in-the-money strike price for both puts and calls:
- Find the difference between the stock price and strike price
- Multiply the result by open interest at that strike
- Add together the dollar value for the put and call at that strike
- Repeat for each strike price
- Find the highest value strike price. This price is equivalent to the max pain price.
The SPDR 500 (SPY) current max pain graph looks like this:
Blot that image from your eyes. It’s worthless. As Options360 members know full well, calculating max pain levels is a complete waste of time for two reasons.
First, the notion that 80% of options expire worthless is a pure myth. As I wrote here, the reason that the 80% myth persists is because only 10% of option contracts are exercised. That is indeed true. But from there can we make the leap that 90% expire worthless?
If we did, we’d be ignoring the 60%-65% of option contracts that are closed out prior to expiration. Remember, an option contract’s only created when there’s both a willing buyer and seller. During the course of any given expiration cycle, the majority of contracts created, which at some point translates into current open interest, gets closed.
This leads to the second point: In the Options360 service, I never let members hold positions until expiration. Credit spreads, such as the bull put spread we had in Salesforce (CRM) , was closed 5 days prior to expiration once 70% of the maximum profit had been achieved.
The reason for closing positions when 70% of max profit’s achieved is a guiding rule for Options360 because no matter how much remains until expiration, the
position no longer has an attractive risk/reward. The bulk of the money has been made and now the risk is asymmetrically larger with further profit potential.
Options360 members already have information and tools to avoid a max pain situation with more important things to worry about than how less knowledgeable traders will lose money.