Replies to post #23311 on Advanced Micro Devices Inc (AMD)

[sgolds]

Paul, 'max pain', this is how I understand it:

(I will assume the reader basically knows how options work. Otherwise this will make no sense at all.)

Funds like to sell options and make money on the time premium, a nice strategy if you have enough money to make it work. So, for the funds, options that expire worthless are the best options of all!

For a set of options which expire on a given date, you can run a calculation on the outstanding call and put contracts to figure out the price at which the most options expire worthless, making the most time value profits for the funds. This is the 'max pain' number. If this number is near enough to the price of the stock then it may be profitable for the fund to trade shares of the stock to get it to close around this number. What they lose on the stock trades, they more than win on the option expiration.

IMO, a max pain of 12.5 would mean that no fund is going to try to manipulate AMD stock because of the huge losses they would take on the stock trades - if they short it down that far, then the short squeeze explosion would be very bad for them.

[jhalada]

Paul,

You group positions of all the option buyers together (long option positions). Then, step through the strike prices, find out the strike price that would cause maximum pain to the holders of these options (meaning minimum payout).

The stock tends to be pulled in direction of the strike price that will cause this maximum pain.

Joe

[HailMary]

Could someone explain "max pain" to me, please?

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...