Maximum Pain: Option Pain Theory
Introduction
Options are a great way to trade, but they're also a risky investment. If you want to minimize your risks and maximize your profits, understanding the concept of maximum pain options and applying it to your trading will help reduce your risks.
Maximum Pain
The maximum pain is the highest price an option will reach before expiring. It’s also known as the “worst case scenario” or “worst possible outcome.”
If you have a call option, then your maximum profit will be the current spot price less your initial payment (or premium). If you are long on a put, then your maximum loss will be equal to the difference between the underlying asset's price and strike price of that particular put contract minus its cost basis (premium).
Option Pain Theory
The theory of maximum pain is different from the theory of maximum profit. The former focuses on the idea that investors will not buy an option if they believe it will be a losing proposition, while the latter assumes that they will do so anyway.
The theory of maximum pain was first put forward by Louis Bachelier in his paper "The Theory of Speculation," published in 1900. It states that there are two types of investors: those who want to make money and those who want to avoid losing money. The latter group must bear some cost when investing in risky assets like stocks or futures contracts (options), meaning that their buying power causes prices for these products to rise—and therefore lowers profits for all other parties involved with these deals (including sellers). This means that if something costs more than its value then only someone desperate enough would buy it; otherwise everyone else would simply sell theirs instead--which leads us right back down into our original question: why would anyone choose this route over another?
Calculation of MP Option
The maximum pain option is calculated by the following formula:
MP Option = (1 - D) * V * H + D * H * V
Value at Risk
The value at risk (VAR) is a measure of the maximum potential loss in a portfolio of financial assets. The VAR is calculated by applying a set of risk factors to historical data. It is intended to be used as an analytical tool, rather than as a trading strategy.
The calculation starts with the net market value (NMV) of all assets, which includes stocks and bonds but excludes cash balances due to their low liquidity; this figure represents how much money you can lose if those assets were sold without regard for price fluctuations or commissions paid on sales made during any given period. Next comes what's called “market exposure”: how much capital would need to be allocated if some portion of your portfolio were invested elsewhere? This number may fluctuate depending on market conditions; however there are several ways that investors can determine this figure themselves without having access only sell orders placed through third parties like banks or brokerages.
Below is the Nifty chart for call and put Max pain which stands at 18400. well, this figure is dynamic and keeps changing with time.
Understanding the concept of maximum pain options and applying it to your trading will help reduce your risks.
The MP option strategy is a good way to reduce risk, especially in bear markets. It’s an alternative to buying puts or calls and can be used in conjunction with other strategies.
The idea behind the MP option strategy is that you buy an at-the-money call option when there’s no reason not to do so (i.e., it has good intrinsic value). You also sell an at-the-money put option at the same strike price when there are no reasons not to sell it either (i.e., its price is abnormally low). In this way, two opposing positions exist on one instrument: You have purchased both calls and puts on one underlying stock; however, they are different amounts—one being cheaper than another—so they will net out against each other when expiring depending upon how far apart their expiration dates fall apart from each other during expiration day/week/month, etc.. You must understand Maximum pain options to be able to make money in Nifty and Bank nifty and for that, you must follow the maximum pain bank nifty or maximum pain nifty to be a step ahead of the option traders.
The theory of options pain belief – "90% of the options expire worthlessly, hence option writers/sellers tend to make money more often, more consistently than the option buyers".
Now if this statement is true, then we can make a bunch of logical deductions –
1. At any point only one party can make money i.e either the option buyers or option sellers, but not both. From the above statement, it is clear that the sellers are the ones making money.
2. If option sellers tend to make maximum money, then it also means that the price of the option on expiry day should be driven to a point where it would cause the least amount of loss to option writers.
3. If point 2 is true, then it further implies that option prices can be manipulated, at least on the day of expiry.
4. If point 3 is true, then it further implies that there exists a group of traders who can manipulate the option prices, at least on the day of expiry.
5. If such a group exists then it must be the option writers/sellers since it is believed that they are the ones who make maximum money/consistently make money trading options.
Now considering all the above points, there must exist a single price point at which, if the market expires, then it would cause the least amount of pain to the option writers (or cause the maximum amount of pain to option buyers).
If one can identify this price point, then it's most likely that this is the point at which markets will expire. The 'Option Pain' theory does just this – identify the price at which the market is likely to expire considering the least amount of pain is caused to option writers.
Conclusion
Here's the good news: you can reduce your risks and make more money by using this concept. We hope that you've found this article helpful, and we wish you all the best in your trading journey.
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