Option Pain

Option Pain - Introduction

Many theories have been raised to explain why some price anomalies prevail in stock prices and some theories even go as far as to suggest the possibility of price anomalies that can be taken advantage of profitably. While stock price anomolies are extremely hard to spot and even harder to quantify and prove emphirically, the search for a reliable way of telling where stock prices will go continue to be the mission for the technical analysis as well as the options trading community. Options trading opened the door to insights that were never before seen and one of this is the parameter known as Open Interest. Option Pain uses open interest in an attempt to predict where stock price will end up.

What Is Option Pain?

Option Pain, also known as Max Option Pain or Max Pain, is based on the theory that since most options buyers lose in options trading, the price of the underlying stock must be manipulated somehow to close during options expiration at a price that results in the most options contracts expiring out of the money. If the Option Pain theory holds, it becomes possible to actually predict the exact price a stock would close at during option expiration through charting the open interest of both call and put options. That exact price is known as "Option Pain" or "Max Pain".

History and background of Option Pain

Very little is known about the origins of Option Pain or who exactly proposed this theory. Earliest account of Option Pain can be traced back all the way to 2004 on the internet where some options traders attempt to devised ways to profit from the Option Pain theory. This alone makes Option Pain a relatively young theory. It is also a theory that is not academically recognized (yet) and has not undergone the rigorous testing needed of any proven statistical models.

Even though it has yet to generate any statistically significant results so far, it has been embraced by the technical analysis and options trading community very quickly and accepted as a technical indicator.

Assumptions of Option Pain

The definition for Option Pain taken from Optionpain.com is:

"In the option 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 market, is called Option Pain. Option Pain is a proxy for the stock price manipulation target by the option selling group."

In this definition, we can extract the following assumptions:

1. "Wealth transfer between option buyers and sellers is a zero-sum game". This means both parties cannot gain or suffer together. In options trading, when one party wins, the other party loses.

2. "On option expiration days, the underlying stock price often moves toward a point that brings maximum loss to option buyers". This means that on option expiration day, most option buyers with open positions loses money.

3. "calculated based on all outstanding options in the market". This means that Open Interest is representative of the number of buyers of stock options.

4. "stock price manipulation target". This means that stock prices can and are manipulated on option expiration days.

5. " by the option selling group". This means that a specialized group of traders exist that manipulates stock prices known as the Option Selling Group.

These assumptions have obvious flaws that make the whole theory less convincing. First of all, the assumption that the underlying stock tends to move towards a point of maximum loss to option buyers has been construed in a wrong way. According to the CBOE and research presented in a book titled Options on Futures by Summa and Lubow, as much as 60% to 80% of all options are exercised or closed out profitably PRIOR to expiration, leaving the final 40% to 20% to expire out of the money since there is no point in closing those positions (real options traders would know that). This means that these final 40 to 20% of option buyers holding their positions all the way to expiration have no real intention on closing out those positions in the first place. In fact, many options strategies involve the purchase of out of the money options which are deliberately allowed to and intended to be expired worthless. As such, there is little or no manipulation needed to expire the bunch of out of the money options in the first place. This is also why you will always see Option Pain graphs presented in a "U" shape with more and more options outstanding as price moves more and more out of the money.

The assumption that open interest is representative of the number of option buyers is also incorrect. Open interest exist as long as there is an open option position. This position can be either a long or short position and their composition isn't reflected in the open interest at all. Without knowing the composition of long and short positions, there is no way stock manipulators (if they exist at all) would know if maximum loss to options buyers can be achieved by closing the stock price higher or lower than the Option Pain price.

Options expiration days are extremely complex especially on quadruple witching days where futures are also expiring on the same day. The complex dynamics on options expiration day creates a volatile market condition where stock prices manipulated prior to it may find it hard to stay at that price and any attempt to manipulate prices on options expiration day itself would find unusually strong resistance. Stock price manipulation on options expiration day is simply not as exact a science as the theory proposed.

Finally and most incredibly, the theory assumes that a professional group of traders exist for the express purpose of manipulating stock prices to the point of Option Pain. First of all, if such a professional group of manipulators exist, their activities would have been discovered and cracked down by now since whatever they need to do needs to get done every single month. Secondly, such an activity would have totally no value whatsoever for the manipulators. By expiration, professional institutional options sellers such as market makers with extremely big positions would have realized as profit almost all of the extrinsic value of all the options sold so far and would have hedged their positions against delta movements. Such a simple hedge is certainly a lot cheaper than the cost of beating down or buying up a stock to its Option Pain level. Also, there is not one single option seller in the options market which owns all the outstanding positions during expiration. Open positions are owned by a diversed group of institutional and private investors which makes a coordinated effort to close the stock at a certain price for common interest improbable (not to mention the fact that that "common interest" do involve some options still expiring in the money). Options trading is now a big and complex market with participants from all over the world, unlike the simple one big player type of situation that the theory seems to propose.

How Option Pain Is Calculated

The method for calculating Option Pain has evolved quite a bit from its emergence in 2004. The earliest method for determining Option Pain is simply looking for the strike price where the most open interest for both call and put options exist. The idea is to end the stock price within the price range bounded by the strike price of the call and put options with the highest open interest. This method has obvious flaws and has generated very bad results. The main problem is that the strike price where the most open interest exist for call and put options may not the price where the most aggregate number of call and put options would expire out of the money at. This is due to the fact that the number of call options and put options traded at any time can be significantly different and is captured in indicators such as the Put Call Ratio. On top of that, nearest the money or at the money options tend to have the most open interest at any one time. This would suggest that the stock should not move all the way to expiration.

A more realistic, albeit more complex, way of determining the point of Max Option Pain was proposed and launched as a calculator at OptionPain.com on January 2008. This method takes the aggregate number of outstanding call and put options into consideration to determine the point where the most number of options, regardless of the mix of call and put options, expires out of the money. If manipulators of stock price really do exist, then this new method would certainly generate more income than the previous method.

How to Profit From Option Pain

It has been proposed from some investment and options trading websites that stocks tend to move towards the Option Pain level as expiration hour approaches and is most predominant in high volume stocks (these are again claims that have yet to be rigorously tested or proven.). Essentially, if you know what price a stock will end up and when, there is almost an endless number of options trading strategies that you can use to take advantage of it. If the Option Pain level is higher than the stock price right now, you could use a Bull Call Spread by buying the At The Money call options and then sell the Out Of The Money call option slightly above or at the Option Pain price. Conversely, if the Option Pain level is lower than the stock price right now, you could use a Bear Put Spread using the same logic. Naked call write and put write at the strike price slightly above or below the Option Pain price works as well.

In fact, it is possible to profit using any of the 3 styles of options trading.

Testing Option Pain

Option Pain has been tested on the most heavily traded stocks over the past couple of years generating no statistically significant proof that stock prices behave as proposed. The tested stocks actually end up outside of the Maximum Option Pain zone most of the time by a significant margin.

Option Pain Conclusion

Option Pain is a very interesting theory, proposing a very interesting use for Open Interest derived from options trading. Even though it has no firm fundamental logic nor has it generated any consistent results that can be empirically proven for options trading, it is no doubt a good attempt at deriving more useful information about future stock prices from the concept of Open Interest. Options Trading has really changed the technical analysis landscape quite a bit with that extra parameter. We would advise caution in attempting to use Option Pain in your options trading. This tutorial does not seek to credit or discredit Option Pain in anyway but to list out objectively its pros and cons in order to make you options trading safer.

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