How to Calculate an Option's Maximum Pain
Original post by Rocco Pendola of Demand Media
The theory of maximum pain refers to the belief that the price of an option's underlying equity (a stock or index) gravitates towards the price where the greatest number of option contracts will expire worthless, as measured by their total dollar value. In this scenario, option holders feel "maximum pain," while option sellers win. Some calculators can figure the maximum pain point for you, but you can take pen to paper and do the math yourself.
Assemble the strike prices and open interest data for all of the option contracts that expire in the month for which you wish to calculate maximum pain. Open interest differs significantly from volume. "Volume" refers to the number of contracts traded, and "open interest" reflects the number of open positions on a particular contract at a given time.
Calculate the cumulative value of the open interest of all the calls and puts for the option contract you are evaluating. As the Optionetics website explains, "This is the value of the options that will NOT expire worthless" at a given strike price. The mathematical equation to complete this step is as follows: difference between the price of underlying equity, minus the options strike price, multiplied by the open interest. As you do this calculation, the value of the calls should increase and the value of the puts should decrease as the underlying equity increases in price.
Add the total dollar value of the open interest for the calls and puts together at each strike price. The smallest number you see reflects the maximum pain price. At this price, option contract holders own options with the lowest combined dollar value, which bodes well for the parties who sold those contracts originally.
About the Author
As a writer since 2002, Rocco Pendola has published numerous academic and popular articles in addition to working as a freelance grant writer and researcher. His work has appeared on SFGate and Planetizen and in the journals "Environment & Behavior" and "Health and Place." Pendola has a Bachelor of Arts in urban studies from San Francisco State University.