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Ask The Analyst, Sunday, 03/14/2004

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 traders.

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 contracts.

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 Friday's trade.

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 $12.90.

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 = $36.40).

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 options.

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 security.

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 share position?

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 QQQ.

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 plans?

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 expiration nears.

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 volatile.

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 higher!

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 suddenly unwind.

Jeff Bailey


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