Max Pain is described as the point at which options expire worthless. The term was is short for "Maximum Pain" indicating that buyers of Options that hold until expiration are likely to see their positions expire worthless.
With that in mind, there are often opportunities on Options expiration Friday based on the Max Pain theory. Enter Max Pain Options Trading Strategy. This is a strategy that benefits when a stock pegs a specific strike price on options expiration day. Here's how it works...
- Find a high volume, high priced stock that has consistently heavy open interest on their Options month to month
- Make sure there are no major catalysts (earnings, news, etc) for the stock on Options expiation Friday (third Friday of every month)
- On expiration day, check the stock around 12pm-1pm EST and see which strike price it is trading nearest...then check the open interest of Puts and Calls on the strikes that surround the stock price
Here's where things get interesting. In order to proceed, you must understand the effect Puts and Calls have on the stock price. As Puts are exercised, the stock price is influenced to the upside due to the buy side impact an exercised Put has on a stock. Vice Versa, as Calls are exercised the stock price is influenced to the downside due to the sell side impact an exercised Call has on a stock.
- Keeping in mind the relationship between Calls, Puts, and stock price we just discussed, look for discrepancies in open interest on Calls vs open interest on Puts
- If there is significantly more open interest on Puts strike prices at or below the current stock price, you are likely to see a little upside action into the close
- If there is significantly more open interest on Calls strike prices at or above the current stock price, you are likely to see a little downside action into the close.
- Play the direction of the discrepancy via an Options Spread that best compliments it.
Let's use GOOG as an example. Say GOOG is trading at 504.00 at 1:00pm on Options expiration Friday. The closest strike is 500, but 510 could be a possible peg as well. Let's now assume the sum of open interest in 500, 510, 520 Calls heavily outweighs the sum of open interest in 500, 490, 480 Puts. This leads us to believe the pressure from exercised Calls will push GOOG down from the current 504.00 price and force it to peg 500.
With that in mind, we decide to buy the front month 490/500/510 Butterfly, which achieves max profit if GOOG pegs the 500 strike price. Let's assume the spread requires a $700 capital risk to make $300 (which is typical in this scenario). This means your reward to risk ratio is skewed against you and time is not on your side (only 3 hours until close), so one must be confident in their analysis as well as the validity of this strategy.