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Thursday, January 15, 2004 12:42:11 PM
It is based on the number of outstanding calls and puts for a given expiration date. I don't have the time right now to write a super long explanation, but I'll give you the basics.
Every strike price has a certain number of contracts open for both puts and calls. Max pain describes the point where all these open contracts (both puts and calls) are worth the least amount in total value for that expiration date. The idea is that calls that are in the money are likely to be exercised and the shares will be immediately sold. The higher the price, the more call options that are worth something are out there. So outstanding calls near the expiration date tend to appear as more sellers of the stock on the market. The opposite is true for put contracts. They tend to appear as more buyers of the stock. The max pain price represents where the number of sellers and buyers are equal.
Some months this can end up being many millions of shares being exercised and then the underlying position getting closed.
The hole in the theory is you don't know the underlying position of the call and put holders. They may exercise and not sell or buy the shares, but rather keep the position. They may do this because they already have an offsetting position, or they just want to continue the position with shares. For instance a call holder may exercise and decide to hold on to the shares instead of immediately sell them. If that call buyer was already short shares, they would simply be covering the short without actually making a stock trade.
But most of the time option holders exercise and immediately close the position. That is the theory.
LOL. That ended up being pretty long...
HailMary
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