The Max Pain option strategy provides valuable data regarding future stock prices. Market forces tend to push the stock price towards the Max Pain point at the close of the stock market on the options expiration dates. With the introduction of weekly options in addition to the monthly options, this means that we have an idea of the closing of the stock price every Friday. For example, the Apple stock trades weekly options. Using this stock option strategy, you can tell where the Apple stock price will be every Friday at the close.
For call or put options, there is an option buyer and an option writer. Max Pain basically means the point where the most open option contracts expire out of money, therefore a "pain" in terms of lost premium for option buyers. The reverse is that this is the point for the least money paid by the option writers. Option writers are usually big players like market makers. These big players protect themselves against the option contracts they take out. This rebalancing of coverage is a major factor in the market forces that are driving the share price to the Max Pain point.
There are two main ways to determine the point of maximum pain. The first and most accurate method is the cash value method. Here, the cash value of all open contracts is calculated. The surrender value is the difference between the exercise price and the share price multiplied by the interest open to strike multiplied by 100 shares per option contract. By calculating the total cash value of all the call and put options for various closing prices, you can determine which closing price has the lowest total cash value. This is the Max Pain point.
The second method is simply to examine the number of open buy and sell contracts combined. The highest open interest is assumed to be the point of maximum pain. This method is inaccurate, however, some people use it because all of the optional data sources (CBOE or yahoo Finance) provide open data of interest. You don't need to do any other calculation than to add the call and put the interest open. Therefore, it's simple and quick. Finding the highest combined put and call interest gives you a general idea of the close of the action. The cash surrender method is more precise and free online calculators do the work for you.
You can make short-term investment decisions using this stock option strategy. If the headline is below this point, you know that there will be significant pressure from the headline to increase but the expiration of the option. You can buy the stock directly or through purchase options. Conversely, if the stock is above this point, you can sell it short or buy put options. You need to buy longer term monthly expiration options and then trade them as if they were weekly options. The weekly options theta decreases the premium very quickly.