Max Pain Indicator: A Primer

I wanted to talk more about Max Pain, and why it's an interesting indicator by market theory.

As I had mentioned in the thread Max Pain had similar assumptions to Gamma Exposure, so let's cover those again.

- MM's hedge with long calls and short puts, as investors are deemed to hedge with long puts and short calls

- MM's hedge to the option delta, to remain delta neutral

Now let's talk about Max Pain's assumptions.

- MM's hedge their written calls/puts as to remain delta neutral

- as expiration approaches, MM's will try and "steer" the underlying to where the greatest number of options expires worthless

Why is this similar to GEX?

Well, they both fall under an assumption of trying to "pin" the stock to a certain value or between a range.

Where Max Pain points to the underlying price where the maximum amount of options expires worthless, GEX points to where the most OI is relative to underlying price. This implicitly keeps the share price above/below the maximum gamma, depending on who has leverage.

Since we've established the difference between Gamma Exposure and Max Pain, let's break down Max Pain a bit more.

How is it calculated?

1) Difference between spot price and strike price

2) Multiply by OI for that strike

3) Add dollar value for C/P at that strike

4) Do this across entire chain

5) Lowest combined value is "Max Pain"

For AAPL, Max Pain is 160, from our data.

Image

The theory assumes that, for this weeks expiration, MM's will be competing against the market to try and get AAPL's close price in that 157.5-165 range, as that would assume the most contracts expire worthless at those levels.

You can utilize Max Pain as a hedging strategy if you're long/short, functionally working as a way to see where the market would want the underlying pinned at expiration. Or, you can use it for directional trading. All of this depends on your personal bias.

As a disclaimer, there is much of this model that is disputed, as assumptions of MM's being permashort calls/puts is debatable. However, more longs are being purchased by retail written shorts in this market, and for some tickers, the Max Pain theory might hold true.

If Max Pain is not your cup of tea, there is also a GEX dashboard on the same page. There are flaws in that, too, but it is important to remember that nothing is absolute in the market, and some indicators have seasonality over others.

But, ultimately, if it helps you make profit, then it works, and that's just how you specifically happen to trade.

Hope this was a helpful explanation, and hope you learned something new today.

As always, please PM me if you have any questions :)