Sunday, August 10, 2008

Max Pain Theory and Options Expiration This Week

Max Pain options theory tells us that the majority of options will expire worthless. The assumption is that most of the call or put options associated with an index or equity will expire worthless. To achieve this the underlying stock has to end the week somewhere above most of the open put options, but below most of the open call options.

Options expirations this month is this Friday August 15. With the big up move on Friday by the stock markets we will have a golden chance to see this theory proven right - or not - as current prices are significantly higher than what the max pain numbers.

Here are some max pain numbers, as well as the current price, and the price differential:

DIA: 114 (current: 116.95, +2.6%)
SPY: 128 (current: 129.37, +1.1%)
XLF: 21 (current: 21.94, +4.4%)
QQQQ: 45 (current: 47.32, +5.1%)

These are the numbers for QQQQ:

A more interesting example is DIA. The following table shows the number of options in-the-money and out-of-the-money, as well as the total $ profits that holders of in the money options could make.

This table shows the revenue that will be made by the options holders once they sell their ITM (in the money) options, not deducting the premiums paid). With Max Pain, there is a difference of $11M in profits. This means that holders of in the money options make less money, and the writers of the options make the most money. Notice also the number of OTM (out of the money) options at expiration. If Max theory is correct, the writers of the options will stand to keep 257,615 contracts, versus 234,388 if the current price stands. That is a a difference of 23,227 contracts. The table below shows the profits made by the options writers at several average premiums charged for these contracts.

Finally, the table below shows the actual profits made by the ITM holders at expiration versus the premium paid.

Note that at an average premium paid of $3.50 no ITM holder actually makes any money as the profits from their sales does not cover the cost of the options. At $5 premium the difference does not make sense as Max Pain theory benefits the buyers (fewer buyers, fewer losses!).

The figures in the two previous tables also clearly show that it its much more advantageous to write options as opposed to buying them. At, for example, $3 premium, the writers stand to make profits of $70M to $77M, while the buyers only make $7M to $11M.

If Max Pain is correct and if these numbers remain the same this week, the markets should correct. It will be very interesting to watch.

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