The Max Pain price for a stock is the price at which, on options expiration day, the sellers (writers) of call and put options minimize their financial obligation to the buyers of the same options.
It has been observed over and over that, in the absence of any unusual market-moving events, stock prices will gravitate toward the Max Pain price as options expiration draws closer. On the day of expiration, especially in the closing minutes of trade, you can see quite dramatic moves toward the Max Pain price.
Let's look at a contemporary example of Max Pain:
At market close on January 5, 2011, Netflix (NFLX) was at $179.73 and Apple (AAPL) was at $334.00. According to optionpain.com (linked at bottom of page), the Max Pain price at options expiration on January 22nd for NFLX is $170 and for AAPL is $290. Assuming the Max Pain phenomenon holds true, one would expect NFLX to trade at close to $170 at the end of the day on January 21, and AAPL to trade at close to $290.
"... In the Absence of Any Unusual Market-Moving Events"
One important caveat to recall is 'in the absence of any unusual market-moving events.
For instance, Apple announces its quarterly results just before options expiration. If Apple announces much better than expected revenue (which many, including the original writer of this article -- JSergeant -- anticipate), the options market makers will probably not have the ability to pin AAPL to a $290 close on January 21. By contrast, NFLX will not announce its earnings until after options expiration. Thus, it will more likely trade as described, even truer due to its much smaller market capitalization (thirty times smaller than AAPL).
I (JSergeant) will add a follow up to this Foolsaurus post to document what actually happens on January 21.
How can you use this information on Max Pain?
If you are planning to buy a stock, you might want to check the Max Pain price for the next option expiration day. If the Max Pain price is below the current stock price, you may want to hold off buying until the option expiration day, or better still, put in a good 'til canceled (GTC) order -- a type of limit order -- to buy the stock at a small premium to the Max Pain price.
Here are two links that provide some more information on this phenomenon:
There is a Max Pain calculator here: