Option expiration and Max Pain
By Jeff Bailey
I received several questions this week regarding Max Pain theory,
which is a theory, based on mathematics and the never-ending goal
of an option market maker to make as much money for himself as
possible as option expiration nears, while at the same time
trying to make life as difficult and as unprofitable for options
I shouldn't beat on market makers. They need to make a living
too, and I've never met a good trader that didn't have profit in
mind. It's OK to want to make a profit, and I really wouldn't
hold it against anyone.
So what is Max Pain theory? In simplistic form, the theory
itself is based on the thought that a security that trades
options, usually with high open interest, might gravitate toward
a mathematically derived average price as option expiration
nears. The Max Pain is really somewhat of a mid-point, or the
average price if you were to add up all the current option open
interest for a particular month at all the various strike prices.
Believe me when I say that that is the "simplistic" version, or
explanation, as it is much more complex, where it would really
take a book of text to be able to explain fully.
Let's take a look at the NASDAQ-100 Tracking Stock (AMEX:QQQ)
$35.51, where the current month Max Pain has been calculated at
approximately $36.00, or the $36.00 strike.
Remember last week's article on the bullish % sector bell curve?
Think of Max Pain as somewhat of a bell curve, where the top of
the curve, is really the mid-point, or point of equilibrium for a
given point in time.
QQQ March Option Contracts - Sorted by Open Interest
Here's a look at a QCharts option chain of the QQQ, where I've
sorted by Open Interest, for the current month March option
We can see that there is greater amount of interest in the March
37 calls and puts, March 36 puts, and March 35 puts, where open
interest begins to drop off from there.
Before we go further with this article, let me say that there are
MANY dynamics in the marketplace that can influence price action,
but as we near an option expiration, price action in an
underlying security can be INFLUENCED near-term, simply from what
takes place in the derivatives market, whether it be futures
expiration, or options expiration.
See the column "NetSinceOpen%" in the above table? That's the
percentage gain/loss found in various option contracts during
Even though the current Max Pain level for the QQQ is calculated
at $36.00, the mindset of a trader/investor could be.... "Who has
the greatest amount of profit risk, from current level of trade?"
Don't just think about RISK from the perspective of an investor,
but also that of the MARKET MAKER.
Thursday evening, the QQQ closed at $34.87, and investors holding
the March $35 puts (QQQOI) long were holding an in the money
contract. One day later (Friday) they're holding an out the
money contract, where if the QQQ closes ABOVE $35.00, the option
would be worthless.
Thursday evening, the QQQ closed at $34.87, and a MARKET MAKER
(it could be your or I that sold a put option short, but a market
maker probably has a greater amount of capital to work with than
you or I) holding a March $35 put short position, who is
OBLIGATED to buy the QQQ at $35.00 should it close at or below
that price level on Friday, March 19, 2004 was holding a
potentially losing position. Potentially losing position,
because we really don't KNOW what his/her average price of
premiums received has been, during market making activities. The
price range for the March $35 put contract has been $0.05 to
QQQ March $35 Put (QQQOI) Chart - Monthly Intervals
If looking at things from the perspective of the MARKET MAKER,
what would we be trying to do with the QQQ right now? For the
past three months, since December's quarterly expiration, the
March $35 put has traded between $0.10 and $1.15, where 668,999
contracts have traded hands since January 1, 2004, yet open
interest at Thursday evening's close was 232,361.
While I can't say for certain, the above chart gives the
perspective that a MARKET MAKER that has been selling these
options to market participants that have been BUYING them, has
probably SOLD an average PREMIUM of $0.60, and should the QQQ
close above $35.00, all that premium is then a profit, where the
MARKET MAKER's break-even is a QQQ close of $35.40 ($36 - $0.60 =
I use the QQQ put as an example, but you can begin to make
similar observations as it relates to other option contracts,
with HIGH open interest, where those option strikes CLOSEST to
current QQQ level of trade has a high degree of PROFIT RISK.
I could also discuss the PROFIT RISK for the MARKET MAKER in the
QQQ $35 calls, but note that the open interest in those calls is
about 1/2 that of the offsetting $35 puts. If YOU were a MARKET
MAKER, where is YOUR attention focused? Right now, you're most
likely FOCUSED on where the open interest in your book is, and
you're trying to keep as much premium profit as possible.
Now that we have a feel for gain/loss on a daily basis, start
looking at those options, based on a QQQ trading at $35.51, where
the LONG position has the greatest PROFIT RISK. Think PROFIT
turning to $0.00. Remember, when YOU or I BUY an option, we've
already factored in what we could LOSE, so when we think of "max
pain," I think it best to think of those options with the
GREATEST PROFIT, where as option expiration nears, those profits
could erode quickly (that's RISK) should price action in the
underlying security suddenly move against the option position.
Do you begin to see what can take place as option expiration
nears? Remember that the clock is ticking as it relates to March
expiration. If you as a MARKET MAKER can "manipulate" or begin
to INFLUENCE price action near-term, to try and achieve MAX
PROFITABILITY for your book, then YOUR risk window is just 5-
days. If successful, then the MARKET MAKER can also inflict Max
Pain on the general public, which tends to BUY LONG call and put
To fully comprehend, or tabulate Max Pain you can begin to see
how complex it becomes, as you really need to fully review and
think through the process of average price paid for the various
contracts that are currently CLOSE to the price of the underlying
One observation that traders have made over time is that Max Pain
levels aren't always accurate as to where the underlying security
actually closes on option expiration.
Why is that?
Besides stating the obvious that some type of major event
(earnings, geopolitical, etc) took place, which impacted price of
the underlying security, Max Pain theory can be inaccurate, or
unreliable, when considering that the derivatives, which the
theory is based upon, may have been heavily used by an
institution(s) to hedge a large position underlying bullish
position, or to actually PURCHASE a position at a specified
strike price, at some future point in time. This is more apt to
be present in individual stocks than indices, but here is why Max
Pain theory can be very unreliable.
Pretend for a moment that the QQQ is actually a company's stock,
and you find that Max Pain for March expiration is $36.00. Let's
also pretend that QQQ trades average daily volume of 5 million
shares per day.
A year ago, a large hedge fund began accumulating QQQ shares,
from $24 to $30 over several months, with full intention of
selling that position in March of 2004 at $36.00. When the
position exceeded the hedge funds price objective at $37, the
hedge fund manager purchased March $36.00 puts for $0.30 per
contract in order to put a floor of profit under the position to
protect those gains.
And here is how a trader (like you and I) that RELIES TOO HEAVILY
on Max Pain theory working, can get in big trouble if they have
relied heavily on the theory working as if price will gravitate
toward the Max Pain level.
Put yourself in the shoes of the hedge fund manager with the now
largely profitable QQQ position and you're ready to sell at your
stated objective of $36. Maybe you wished you had sold at $38,
but things were looking very promising at that price level, and
it wasn't time to reallocate your assets. Still you can't
complain considering the current profits you have amassed.
But wait! There might still be opportunity.
A hedge fund manager is out to make a profit just like the next
guy. What if the QQQ is trading $35.51 the day BEFORE, or the
day OF expiration, and YOU, the hedge fund manager are holding
50,000 March $36 puts, which covers your 5,000,000 underlying
Hey! As the hedge fund manager, you might decide to let go of
your position in the public market, and utilize your large long
position in the underlying QQQ to see and exponential price gain
be created in your March $36 puts!
This type of scenario is where Max Pain theory can be very
unreliable, where the mathematical theory that just because there
is a lot of open interest around the $36.00 level would have the
QQQ closing at or near $36. The above scenario of a large
position suddenly being liquidated on or around expiration, in
order to actually further profit from the option position is not
all that uncommon.
A hedge fund could actually INFLUENCE other market participants
to sell their bullish positions in the underlying stock, or get
market participants to suddenly, and with aggression, begin
buying put options, selling in the money call options where
PROFIT RISK was found, if a sudden downward move is seen in the
Do you see where the VOLATILITY sometimes found around, or near
option expiration can be found? Do you see where a trader that
has relied HEAVILY on Max Pain theory actually coming to fruition
can be harmed if the actual Max Pain theory level is not
achieved, but actually works against the trader's best laid
That's just one scenario where you could see a Max Pain theory of
$36 see a downside move.
Even with a stock trading at $35.51 in to expiration, with a Max
Pain of $36, doesn't mean the stock can jump to $36.50 as
A scenario here would be that of a hedge fund manager decided in
January, when the QQQ was trading above $36, that he/she going to
buy the QQQ at $35 in March, should the QQQ pull back to that
level or lower, but wasn't willing, or didn't have the capital at
the time to begin building the bullish position. So instead,
decided to sell naked (short) the QQQ March $35 puts (QQQOI) for
$0.30 per contract, and sold 50,000 contracts, taking in
$15,000.00 in premium.
If you were the hedge fund manager and had already determined
that you were a buyer of QQQ at $35.00, it might not be beyond
your ability to MANIPULATE things to your liking and come into
the market and begin buying your QQQ position up to $35.30
(you're going to buy it anyway from the naked put sale which
OBLIGATED you to buy it at $35.00 less the $0.30 premium
received) and once you filled your position, perhaps influencing
market participants to drive price higher, you've not only kept
the naked put premium, but the stock and your underlying position
is now working well within your favor.
What can be helpful to know about Max Pain levels is to simply
have an observation of where there is derivative interest that
surrounds a particular price level, which can help a trader or
even an investor understand where they might look for a security
to gravitate toward into expiration, but also understand, or be
prepared when considering entering or exiting a position, how
EXTREME PRICE VOLATILITY can be created.
Remember that Max Pain theory is based on the options market,
which is a derivative, where that very derivative allows for high
amount of leverage. Its when that leverage suddenly unwinds that
an underlying security's PRICE action can become just so
If you don't see how this can be, you must once again put
yourself in the shoes of an options MARKET MAKER.
Take the last scenario as the example. If you the market maker
have sold short the to market the March $35 puts and the March
$36 puts, you're happy that QQQ price action is above $35 and
moving higher. But what are you going to do with about the March
$35 calls, or more importantly the March $36 calls when suddenly,
your book is short 169,323 contracts at an average premium
received of $0.50 and the QQQ is trading $36.50?
There are a lot of things you can do. You can try and get long
16,932,000 shares of the underlying position, as you being NAKED
the $36 calls has you OBLIGATED to deliver 16.9 million shares
should the QQQ close above the $36 strike on expiration.
Again, if this were a stock, and not the QQQ which does trade
with a high degree of liquidity, getting long (buying) 16.9
million shares the day of, or a couple of days before expiration
could be a big problem, where suddenly, you the MARKET MAKER is
actually driving price action in the market.
Heck, suddenly, you're selling in the money March PUTS at $37,
$38 because you know the more underlying stock you're buying to
fulfill your OBLIGATIONS in the $35 and $36 calls is going to
most likely have YOU, and other market participants driving price
Here you can see how this high degree of leverage, which
surrounds a specific strike price, can suddenly bring a great
amount of price volatility to the underlying security, if price
moves "too far" away from the Max Pain level.
I know this topic is rather complex. Max Pain isn't a simple, or
cut and dried mathematical theory, that can be thought of as
being highly reliable. Max Pain levels can work to perfection,
and they can blow up where extreme price volatility away from the
gravitation point is found, should the unwinding of the
derivatives market take place.
The lesson to be learned is to try and understand how the Max
Pain level is derived, and how it can serve as a gravitational
point toward an option expiration. The other lesson to be
learned is the implications of making big bets into an option
expiration, if you aren't aware of how, or why, price volatility
of securities can be created should a large derivative trade