Unlock Big Gains with the Max Pain Trading Strategy

Did you know that smart money uses the Max Pain Trading Strategy to manipulate the market with their substantial financial power? By leveraging their significant capital and market insights, they steer market trends to align with their positions. This kind of market manipulation allows smart money to reap substantial profits.

You might wonder how they manage to influence the market so effectively. I had the same question when I first learned about this. The answer lies in their use of the Max Pain Trading Strategy. This strategy drives the market to the desired positions of these powerful players, underpinning much of the market manipulation attributed to the Max Pain theory.

In this blog post, I will cover how smart money manipulates the market using financial power and the Max Pain. We will delve into how the Max Pain level is determined, what it signifies, the accuracy of the Max Pain theory, and the effects on a stock when it reaches that level. Most importantly, you will learn how this strategy can help you understand the mindset of smart money in the market. Get ready to explore!

Max Pain Option Trading Strategy
Max Pain Strategy

Understanding the Max Pain Theory

Before diving into the theory, it's important to understand a key fact in the options world: Option Sellers, or Writers, are considered more powerful and therefore make most of the profits. Two main reasons support this assertion.

First, Option Writers need significantly more capital compared to Option Buyers. Option writing requires a larger margin, which is why those with deeper pockets are drawn to this strategy.

Secondly, the major players in option selling are large institutions (FIIs and DIIs) and high-net-worth individuals. These entities typically have powerful teams with superior research capabilities, essentially making them the smart money in the market.

Although option selling carries the potential for limited profit but unlimited loss, it remains popular among those with substantial capital due to the mathematical edge it offers.

Now, let's get to the core concept. The Max Pain Theory posits that option sellers aim to drive the price of a stock or index towards a point where option buyers will incur the maximum loss as the expiration date approaches. Since options are a zero-sum game, when option sellers profit, option buyers lose, and vice versa.

The point where buyers experience the greatest loss is known as the point of maximum pain, which translates into maximum gains for option writers. Therefore, the Max Pain Theory could also be referred to as the Maximum Gain Theory.

How the Max Pain Strategy Works

On options expiry, all OTM (Out of the Money) options (both Puts and Calls) expire worthless. When an option expires worthless, it represents the maximum profit point for the option sellers. For example:

Nifty option Chain
Nifty Option Chain  (Sensibull)

Consider the Nifty Option Chain, where the 23000 call strike has an LTP of Rs. 184. If an option writer sells this option and it expires OTM, its value drops to zero. Thus, the maximum profit the seller can make is Rs. 184. This illustrates why an option expiring worthless yields maximum profit for the seller.

Conversely, if a buyer purchases the same strike at Rs. 184 and holds it until expiry, it will become worthless, resulting in a maximum loss of Rs. 184 for the buyer. This clearly shows how the maximum loss for one party becomes the maximum profit for the other.

How Max Pain is calculated

Before delving deep into the strategy, it's important to familiarize yourself with these basic terminologies:

Strike Price: The strike price is the predetermined price at which an option buyer obtains the right to buy shares, and sellers are obligated to deliver shares when the option is exercised.

Premium (LTP): To acquire the right to buy shares at the predetermined price, the option buyer pays a price to the option sellers, known as the premium. In the example provided, with a strike price of 23000, the premium paid by the option buyer was Rs. 184 to the seller.

Expiry: Expiry, or expiration date, is the date on which an options contract becomes invalid, and the right to exercise it ends. Options must be exercised on or before this date. In the given example, the expiry date is shown at the top of the option chain as 6th June.

Open Interest: Open interest refers to the total number of outstanding contracts yet to settle, deliver, or close. It serves as an indicator of liquidity for an option.

These terms will be used in our calculations, so it's beneficial to understand them. If you're interested in exploring further, this beginner's guide to the option chain can provide additional insights.

Calculating Max Pain for Nifty

Currently, Nifty is trading around 22737, with the Max Pain level at 22700. At the 22700 strike price, there are 72 lakh open interest contracts on the call side and 87 lakh on the put side. The call option's LTP is Rs. 77, while the put option's LTP is Rs. 65. Refer to the image below for more details.

Nifty Option Chain Sensibull

Let's calculate the total value of open interest at the 22700 strike price:

Price value of Call Open Interest at 22700: 72 lakh * 77 = Rs.554.4 crore

Price value of Put Open Interest at 22700: 87 lakh * 65 = Rs.566.5 crore

Total value (Call + Put) for Strike 22700: 554.4+566.5 = Rs.1120.9 crore (Approx.)

You Should Read : Pros and Cons of Day Trading

Similarly, if you calculate the value of other strikes like 22500 and 22800, it will be around Rs. 1600 crore and Rs. 1500 crore respectively. Refer to the image below for more details, illustrating the max pain levels at various Nifty strike prices.

This total value indicates the amount of loss option sellers would incur if Nifty expires around a particular strike price. In this scenario, option sellers will face the minimum loss if Nifty expires around 22700, as all other OTM options will expire worthless, resulting in significant profits for them. Conversely, option buyers will experience maximum loss since all OTM strikes will expire worthless.

In the event of a black swan, if Nifty expires at 24950, option sellers will face maximum loss, as indicated by the highest bar at 24950. Similarly, if Nifty expires below 20450, option sellers will also incur substantial losses.

In the image above, higher bars represent greater pain for option sellers, while lower bars represent minimal pain for them.

How Use Max Pain Strategy

To implement the Max Pain Strategy, closely monitor the current price of the underlying asset and the Max Pain level. In the example above, Nifty is trading at 22737, while the Max Pain level is at 22700. Since the Max Pain level is below the current trading price, this suggests that option sellers will attempt to bring Nifty's price down to or below 22700 by expiration. This is the essence of the Max Pain Theory.

How do they Bring Price Around the Max Pain Level?

As previously discussed, option writers are considered smart money due to their substantial financial power. They leverage this power to position themselves in a way that drives the price towards the Max Pain level.

Do Option sellers always succeed in bringing the Price at Max Pain Level?

It is not guaranteed that option sellers will always succeed in bringing the price to the Max Pain level by expiration. Sometimes they may fail drastically, while other times they may succeed. Nevertheless, the Max Pain level plays an important role in market analysis. By observing it, you can predict market trends.

Understanding the Dynamics of the Max Pain Level : Finding Trend With Max Pain Shift

The Max Pain level is dynamic and constantly shifts either downward or upward. When it moves downward, it can be interpreted as a sign of a downtrend or market weakness. Conversely, upward shifts indicate an uptrend or market strength.

For example, on June 4, 2024, Nifty closed at 21884, while the Max Pain level was at 22350. Since the Max Pain level was above the Nifty price, it indicated a bullish outlook.

You should read thisDemystifying market trend for a Beginner

The next day, Max Pain shifted to 22450, and by June 6, 2024, it had moved to 22700. This upward shift in the Max Pain level triggered a significant rally in Nifty, which touched the 22800 level intraday.

By tracking these shifts, you can detect market trends. In this article, I am using EOD (End of Day) Max Pain data for analysis, but you can also observe these shifts intraday. I use Opstra Option Analytics for historical Max Pain data.

You can share your experience with Max Pain with me, or if you want to discuss more about this data, you can join us on Telegram at OI in Action.

I am not registered with SEBI. This article is purely for educational purposes. Any stocks or sectors mentioned should not be construed as buy or sell recommendations. Please consult with your financial advisor before making any investment decisions.

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