13.1 – My experience with Option Pain theory
In the never ending list of controversial market theories, the theory of ‘Option Pain’ certainly finds a spot. Option Pain, or sometimes referred to as ‘Max Pain’ has a significant fan following and probably an equal number of people who despise it. I’ll be honest; I’ve been in both camps! In the initial days of following Option Pain, I was never able to make money consistently. However, overtime I found methods to improvise on this theory to suit my own risk appetite, and that yielded a decent result. Later in the chapter I will discuss this as well.
Anyway, now this is my attempt to present you the Option Pain theory and talk to you about what I like and what I don’t about Max Pain. You can take cues from this chapter and decide for yourself which camp you want to be in.
So, let’s get started.
13.2 – Max Pain Theory
The origins of Option Pain dates back to 2004. So, in a sense, this is still a very young theory. As far as I know there are no academic/scholastic papers on it, which makes one wonder why the academia has ignored this concept.
The theory of options pain stems as a corollary to the belief – “90% of the options expire worthless, hence option writers/sellers tend to make money more often, more consistently than the option buyers”.
Now if this statement is true, then we can make a bunch of logical deductions –
- At any point only one party can make money i.e either the option buyers or option sellers, but not both. From the above statement, it is clear that the sellers are the ones making money.
- If option sellers tend to make maximum money, then it also means that the price of the option on expiry day should be driven to a point where it would cause least amount of loss to option writers.
- If point 2 is true, then it further implies that option prices can be manipulated, at least on the day of expiry.
- If point 3 is true, then it further implies that there exists a group of traders who can manipulate the option prices, at least on the day of expiry.
- If such a group exists then it must be the option writers/sellers since it is believed that they are the ones who make maximum money/consistently make money trading options.
Now considering all the above points, there must exist a single price point at which, if the market expires, then it would cause least amount of pain to the option writers (or cause maximum amount of pain to option buyers).
If one can identify this price point, then it’s most likely that this is the point at which markets will expire. The ‘Option Pain’ theory does just this – identify the price at which the market is likely to expire considering least amount of pain is caused to option writers.
Here is how optionspain.com formally defines Option Pain – “In the options market, wealth transfer between option buyers and sellers is a zero sum game. On option expiration days, the underlying stock price often moves toward a point that brings maximum loss to option buyers. This specific price, calculated based on all outstanding options in the markets, is called Option Pain. Option Pain is a proxy for the stock price manipulation target by the option selling group”.
13.3 – Max Pain Calculation
Here is a step by step guide to calculate the Max Pain value. At this stage, you may find this a bit confusing, but I recommend you read through it all the same. Things ill get clearer once we take up an example –
Step 1 – List down the various strikes on the exchange and note down the open interest of both calls and puts for these strikes.
Step 2 – For each of the strike price that you have noted, assume that the market expires at that strike.
Step 3 – Calculate how much money is lost by option writers (both call option and put option writers) assuming the market expires as per the assumption in step 2.
Step 4 – Add up the money lost by call and put option writers.
Step 5 – Identify the strike at which the money lost by option writers is least.
This level, at which least amount of money is lost by option writers is the point at which maximum pain is caused to option buyers. Therefore this is the price at which the market is most likely to expire.
Let us take up a very simple example to understand this. For the sake of this example, I’ll assume there are only 3 Nifty strikes available in the market. I have made a note of the open interest for both call and put options for the respective strike.
|Strike||Call Option OI||Put option OI|
Scenario 1 – Assume markets expires at 7700
Remember when you write a Call option, you will lose money only if the market moves above the strike. Likewise, when you write a Put option you will lose money only when the market moves below the strike price.
Therefore if the market expires at 7700, none of the call option writers will lose money. Which means call option writers of 7700, 7800, and 7900 strikes will retain the premiums received.
However, the put option writers will be in trouble. Let’s start with the 7900 PE writers –
At 7700 expiry, 7900 PE writers would lose 200 points. Since the OI is 2559375, the Rupee value of loss would be –
= 200 * 2559375 = Rs.5,11,875,000/-
7800 PE writers would lose 100 points, the Rupee value would be
= 100 * 4864125 = Rs.4,864,125,000/-
7700 PE writers will not lose any money.
So the combined money lost by option writers if the markets expire at 7700 would be –
Total money lost by Call Option writers + Total money lost by Put Option writers
= 0 + Rs.511875000 + 4,864125000 = Rs.9,98,287,500/-
Keep in mind that total money lost by Call Option writers = money lost by 7700 CE writer + money lost by 7800 CE + money lost by 7900 CE
Likewise the Total money lost by Put Option writers = money lost by 7700 PE writer + money lost by 7800 PE + money lost by 7900 PE
Scenario 2 – Assume markets expires at 7800
At 7800, the following call option writers would lose money –
7700 CE writers would lose 100 points, multiplying with its Open Interest we get the Rupee value of the loss.
100*1823400 = Rs.1,82,340,000/-
Both 7800 CE and 7900 CE seller would not lose money.
The 7700 and 7800 PE seller wouldn’t lose money
The 7900 PE would lose 100 points, multiplying with the Open Interest, we get the Rupee value of the loss.
100*2559375 = Rs.2,55,937,500/-
So the combined loss for Options writers when market expires at 7800 would be –
= 182340000 + 255937500
Scenario 3 – Assume markets expires at 7900
At 7900, the following call option writers would lose money –
7700 CE writer would lose 200 points, the Rupee value of this loss would be –
200 *1823400 = Rs.3,646,800,000/-
7800 CE writer would lose 100 points, the Rupee value of this loss would be –
100*3448575 = Rs.3,44,857,500/-
7900 CE writers would retain the premiums received.
Since market expires at 7900, all the put option writers would retain the premiums received.
So therefore the combined loss of option writers would be –
= 3646800000 + 344857500 = Rs. 7,095,375,000/-
So at this stage, we have calculated the total Rupee value loss for option writers at every possible expiry level. Let me tabulated the same for you –
|Strike||Call Option OI||Put option OI||Loss value of calls||Loss value of Puts||Total loss|
Now that we have identified the combined loss the option writers would experience at various expiry level, we can easily identify the point at which the market is likely to expire.
As per the option pain theory, the market will expire at such a point where there is least amount of pain (read it as least amount of loss) to Option sellers.
Clearly, from the table above, this point happens to be 7800, where the combined loss is around 438277500 or about 43.82 Crores, which is much lesser compared to the combined loss at 7700 and 7900.
The calculation is as simple as that. However, I’ve used only 3 strikes in the example for simplicity. But in reality there are many strikes for a given underlying, especially Nifty. Calculations become a bit cumbersome and confusing, hence one would have to resort to a tool like excel.
I’ve calculated the option pain value as of today (10th May 2016) on excel, have a look at the image –
For all the available strikes, we assume market would expire at that point and then compute the Rupee value of the loss for CE and PE option writers. This value is shown in the last column titled “Total Value”. Once you calculate the total value, we simply have to identify the point at which the least amount of money is lost by the option writer. You can identify this by plotting the ‘bar graph’ of the total value. The bar graph would look like this –
As you can see, the 7800 strike is the point at which option writers would lose the least amount of money, so as per the option pain theory, 7800 is where the market is likely to expire for the May series.
Now that you have established the expiry level, how can you use this information? Well, there are multiple ways you can use this information.
Most traders use this max pain level to identity the strikes which they can write. In this case, since 7800 is the expected expiry level, one can choose to write call options above 7800 or put options below 7800 and collect all the premiums.
13.4 – A Few Modifications
In the initial days, I was very eager to learn about Option Pain. Everything about it made absolute sense. I remember crunching numbers, identifying the expiry level, and writing options to glory. But shockingly the market would expire at some other point leaving me booking a loss and I wondering if I was wrong with my calculations or if the entire theory is flawed!
So I eventually improvised on the classic option pain theory to suit my risk appetite. Here is what I did –
- The OI values change every day. This means the option pain could suggest 7800 as the expiry level on 10th of May and may very well suggest 8000 on 20th of May. I froze on a particular day of the month to run this computation. I preferred doing this when there were 15 days to expiry.
- I identified the expiry value as per the regular option pain method.
- I would add a 5% ‘safety buffer’. So at 15 days to expiry, the theory suggest 7800 as expiry, then I’d add a 5% safety buffer. This would make the expiry value as 7800 + 5% of 7800 = 8190 or 8200 strike.
- I would expect the market to expire at any point between 7800 to 8200.
- I would set up strategies keeping this expiry range in mind, my most favorite being to write call options beyond 8200.
- I would avoid writing Put option for this simple belief – panic spreads faster than greed. This means markets can fall faster than it can go up.
- I would hold the options sold up to expiry, and would usually avoid averaging during this period.
The results were much better when I followed this method. Unfortunately, I never tabulated the results, hence I cannot quantify my gains. However if you come from a programming background, you can easily back test this logic and share the results with the rest of community here. Anyway, at a much later stage I realized the 5% buffer was essentially taking to strikes which were approximately 1.5 to 2% standard deviations away, which meant the probability of markets moving beyond the expected expiry level was about 34%.
If you are not sure what this means, I’d suggest you read this chapter on standard deviation and distribution of returns.
You can download the Option Pain computation excel.
13.5 – The Put Call Ratio
The Put Call Ratio is a fairly simple ratio to calculate. The ratio helps us identify extreme bullishness or bearishness in the market. PCR is usually considered a contrarian indicator. Meaning, if the PCR indicates extreme bearishness, then we expect the market to reverse, hence the trader turns bullish. Likewise if PCR indicates extreme bullishness, then traders expect markets to reverse and decline.
To calculate PCR, all one needs to do is divide the total open interest of Puts by the total open interest of the Calls. The resulting value usually varies in and around one. Have a look at the image below –
As on 10th May, the total OI of both Calls and Puts has been calculated. Dividing the Put OI by Call OI gives us the PCR ratio –
37016925 / 42874200 = 0.863385
The interpretation is as follows –
- If the PCR value is above 1, say 1.3 – then it suggests that there are more Puts being bought compared to Calls. This suggests that the markets have turned extremely bearish, and therefore sort of oversold. One can look for reversals and expect the markets to go up.
- Low PCR values such as 0.5 and below indicates that there are more calls being bought compared to puts. This suggests that the markets have turned extremely bullish, and therefore sort of overbought. Once can look for reversals and expect the markets to go down.
- All values between 0.5 and 1 can be attributed to regular trading activity and can be ignored.
Needless to say, this is a generic approach to PCR. What would really make sense is to historically plot the daily PCR values for say 1 or 2 years and identify these extreme values. For example for Nifty value such as 1.3 can indicate extreme bearishness, but for say Infy something like 1.2 could be extreme bearishness. So you need to be clear about this, hence back testing helps.
You may wonder why the PCR is used as a contrarian indicator. Well, the explanation to this is rather tricky, but the general opinion is this – if the traders are bearish/bullish, then most of them have already taken their respective position (hence a high/low PCR) and therefore there aren’t many other players who can come in and drive the positions in the desired direction. Hence the position will eventually be squared off which would drive the stock/index in the opposite direction.
So that’s PCR for you. You may come across many variants of this – some prefer to take the total traded value instead of OI, some even prefer to take the volumes. But I personally don’t think it is required to over-think PCR.
13.6 – Final thoughts
And with this, I’d like to end this module on Options, which has spread across 2 modules and 36 chapters!
We have discussed close to 15 different option strategies in this module, which I personally think is more than sufficient for retail traders to trade options professionally. Yes, going forward you will encounter many fancy option strategies, perhaps your friend will suggest a fancy option strategy and show off the technicalities of the strategy, but do remember – ‘fancy’ does not really translate to profit. Some of the best strategies are simple , elegant and easy to implement.
The content we have presented in both, Module 5 and Module 6, is written with an intention of giving you a clear picture on options trading – what is possible to be achieve with options trading and what is not possible. We have thought through and discussed what is required and what isn’t. Frankly these two modules are more than sufficient to answer most of your concerns/doubts related to options.
So please do take some time to read through the contents here, at your own pace, and I’m certain you will you will start trading options the way it is supposed to be done.
Finally, I hope you will enjoy reading this as much as I enjoyed writing this for you.
Good luck and stay profitable!
Key takeaways from this chapter
- Option Pain theory assumes that the option writers tend to make more money consistently compared to option buyers.
- Option pain assumes that option writers can influence the price of options on the day of expiry.
- One can use the theory of option pain to identify the price at which the stock/index is likely to expiry.
- The strike at which the option writers would experience least amount of loss is the strike at which the stock/index likely to expire.
- The PCR is calculated by dividing the total open interest of Puts by the total open interest of the Calls.
- The PCR is considered as a contrarian indicator.
- Generally a PCR value of over 1.3 is considered bearish and a PCR value of less than 0.5 is considered bullish.