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How to use Max Pain in Trading

In F&O, most of the retail traders are option buyers. On the other hands, the option selling is done by big players like large institutions. We have already discussed that option sellers take unlimited risks so they have very good insights of the market and they generally believe in the mathematics behind the option selling. They use the fact in their favour that is the most of the option strikes expires worthless precisely 90 per cent. So, they make money consistently.

Here are a few facts about the option:

  • Option is Zero Sum game. It means only one party can make money at a time - either the option buyers or sellers, but not both.
  • As we discussed above, option sellers make money consistently as they use mathematics behind it, so they drive the price towards the strike where they make maximum money and minimum loss whereas buyers get maximum loss and minimum gain.
  • Therefore, they try to manipulate the option prices according to their investment at least on the expiry day.



 When you buy calls or puts, all the OTM options expire worthless. But what is OTM for the call will be ITM for the put and what is OTM for the put will be ITM for the call. That is where the point of Maximum Option Pain comes in the play.

What is the Max Pain theory?

Option Pain or Max Pain is the point or the strike price where the largest number of options open interest will expire worthless. In other words, Max Pain is the strike where the combined open interest of calls and puts is the highest.

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Let’s understand it with the above image that represents Positional Open Interest of the Nifty having expiry on 11th June. This image is generated by Telegram Bot for free in the real-time, alternatively, you can also check it on the NSE website. The bar indicates the OI at a particular strike.



Strikes
Call OI (in lakh)
Put OI (in lakh)
Combined OI
9950
0.23
1.66
1.89
10000
7.31
15.91
23.22
10050
0.51
1.60
2.11
10100
8.42
8.63
17.05
10150
2.32
1.37
3.69
10200
15.79
4.71
20.5
10250
1.39
0.07
1.46
10300
17.96
1.19
18.88
10350
1.31
0.03
1.34
10400
12.96
0.31
13.27
10450
1.8
0.01
1.81

If you look at the yellow shaded portion, it is at a strike of 10,200 that have the maximum combined allocation of calls and puts OI. While individually there may be strikes with higher OI accumulation such as 10300 call however, it is 10200 strike that is seeing the maximum combined OI accumulation. And this strike is called as the max pain strike.

However, you must keep in mind that these options OI data is subject to constant change and hence needs to be calculated on a real-time basis.

For now, it means that the option expiry for the Nifty will converge towards the level of 10,200. This number alone may not mean a much, however, if you track the max pain in real-time, you can track if the price at the time of expiry will go down or up.



Can you rely on Max Pain?
It is true that option sellers have a better idea thus they control the price compare to the retail traders. So, you can take advantage of the max pain theory as the theory holds that when expiration approaches, stock or index price will gravitate toward the price that will cause maximum pain to the option buyers. As option pain is the point at which buyers lose the most and sellers gain the most. If you understand this concept, then even as an option buyer, you can profit from this theory and can avoid a few common mistakes of the option trading.

How to use Max Pain theory?
Max Pain shifted up or down in the real-time. And if you track this, you may get an idea of the direction in which market heads.
  • If Max pain shifts up on the strike - simply indicates the market may move upside.
  • If max pain shifts down on the strike - indicates the market may go down.
The Bottom Line
This is a new theory, there is no confirmation of such types of control on the price so you should you use the max pain theory with a combination of PCR, Price action or OI analysis or fundamental analysis.


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How to use Max Pain in Trading Reviewed by Kumar Chandan on June 06, 2020 Rating: 5

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