Special Strategy for weekly option: MAX PAIN THEORY with PCR..... Don't Miss.....

My Learning with Option Pain theory

As far as Option theory is concern, it is always uncertain to say it is perfect model suited for all for all type of situation, Better to derived some outcome which gives us significant fan following and constant result. In initial days of trading I never analyze such theory even I haven’t make constant profit pointed out here. Over a period of time by analyzing various theory and model and strategy trying constant to derive some concept which help trader to take decision based on option position. 

Option Pain theory requires you to be familiar with the concept of Open Interest.

 Max Pain Theory

The origins of Option Pain dates back to 2004. It is very new and dynamic concept yet. Due to As far as I know there are no academic/scholastic papers on it, which makes one wonder why the academia has ignored this concept.

The theory of options pain explains that most of time says “90% of the options expire worthless; hence option writers/sellers mint tons of money from the market.

Lets us discuss few finding from above statement that 90% case option expires worthless…..

At any point of time due to Zero sum Game either option buyer make money or seller, Here it is clear stated that option seller makes money in most the time.

If the above statement is true it mean option seller make maximum money it means the price of the option on expiry day should be favorable to option Writer only.

If the above point prove true it implies price of option can be manipulated at least on expiry day.

If price is set as pet option seller it is certain that there is something call group of trader who can manage market and option prices at least for one day on expiry.

If such group exits in the market must be seller of option and who believe that market will move in the pre decided range where such group of trader make maximum money from trading option.

To come up at solution we must think there is a point where option seller or writers bears minimum loss or least pain from option chain. So, there must be single price where option writers not bother or ready to accept expiry close.

To identify this point, decide at which point or level option will expire based on Option Pain theory by identifying market expiry with minimum pain to the option writers.

Max Pain Calculation

Let’s start calculation of Max pain value to the option Writers step by step. It is complex process but read slowly and repeat 2-3 times makes it easy and clear. Take an example make it easy and logical…..

·        Point out close of market today i.e. Index or Spot ( Weekly Option)

·        List out 10 strike of option index open interest both calls and puts for these strikes

·        Take each of the strike prices that we noted, assume market expires at that strike only.

·        Calculate how much money option writer lost if market close at same strike price as we noted above

·        Make sum of call and put option writers

·        Identify the strike where option Writers is having least pain or loss.

 It is the level where Option seller is having less pain indirectly maximum pain to option buyers. So, this is the price at which market is most likely to expire.

Let us take up example to understand this theory in detail with taking 3 nifty weekly strike of MAY 2019 series with open interest data.

Nifty 50 close as on 08-05-2019 is 11,360

Nifty 50 Future close as on 08-05-2019 is 11,420

Strike	call Open Interest	Put open interest
11200	6225	232125
11300	47175	244575
11400	408000	523050

Scenario 1 – Assume markets expires at 11200

Remember when you write a Call option, you will lose money only if the market moves above the strike. Likewise, when you write a Put option you will lose money only when the market moves below the strike price.

Therefore if the market expires at 11200, none of the call option writers will lose money. Which means call option writers of 11200, 11300, and 11400 strikes will retain the premiums received.

However, the put option writers will be in trouble. Let’s start with the 11400 PE writers –

At expiry, 11400 PE writers would lose 200 points. Since the OI is 523050, the Rupee value of loss would be –

= 200 * 523050 = Rs. 104610000/-

11300 PE writers would lose 100 points, the Rupee value would be

= 100 * 244575 = Rs. 24457500/-

11200 PE writers will not lose any money.

So the combined money lost by option writers if the markets expire at 11200 would be –

Total money lost by Call Option writers + Total money lost by Put Option writers

= 0 + Rs.104610000 + 24457500 = Rs. 129067500/-

Keep in mind that total money lost by Call Option writers = money lost by 11200 CE writer + money lost by 11300 CE + money lost by 11400 CE

Likewise the Total money lost by Put Option writers = money lost by 11200 PE writer + money lost by 11300 PE + money lost by 11400 PE

Scenario 2 – Assume markets expires at 11300

At 11300, the following call option writers would lose money –

11200 CE writers would lose 100 points; multiplying with its Open Interest we get the Rupee value of the loss.

100*6225 = Rs.622500/-

Both 11300 CE and 11400 CE seller would not lose money.

The 11200 and 11300 PE seller wouldn’t lose money

The 11400 PE would lose 100 points, multiplying with the Open Interest, we get the Rupee value of the loss.

100*523050 = Rs.52305000/-

So the combined loss for Options writers when market expires at 11300 would be –

= 622500 + 52305000

= Rs. 52927500/-

Scenario 3 – Assume markets expires at 11400

At 11400, the following call option writers would lose money –

11200 CE writer would lose 200 points, the Rupee value of this loss would be –

200 *6225 = Rs.1245000/-

11300 CE writer would lose 100 points, the Rupee value of this loss would be –

100*47175 = Rs.4717500/-

11400 CE writers would retain the premiums received.

Since market expires at 11400, all the put option writers would retain the premiums received.

So therefore the combined loss of option writers would be –

= 1245000 + 4717500 = Rs. 5962500/-

So at this stage, we have calculated the total Rupee value loss for option writers at every possible expiry level. Let me tabulated the same for you –

Strike	call Open Interest	Put open interest	loss of call	loss of put	Total loss
11200	6225	232125	0	129067500	129067500
11300	47175	244575	622500	52305000	52927500
11400	408000	523050	10057500	0	10057500

Now that we have identified the combined loss the option writers would experience at various expiry levels, we can easily identify the point at which the market is likely to expire.

As per the option pain theory, the market will expire at such a point where there is least amount of pain (read it as least amount of loss) to Option sellers.

Clearly, from the table above, this point happens to be 11400, where the combined loss is around 10057500 or about 1.005 Crores, which is much lesser compared to the combined loss at 11200 and 11300.

The calculation is as simple as that. However, I’ve used only 3 strikes in the example for simplicity. But in reality there are many strikes for a given underlying, especially nifty weekly 16-May-2019 Calculations become a bit cumbersome and confusing, hence one would have to resort to a tool like excel.

I’ve calculated the option pain value as of today (16th May 2019) on excel, have a look at the image –

Option chain data link daily for open interest of call and put ..... 

Ready Download Max Pain Calculator here Free Calculator

Nifty Weekly Expiry as on 16th may 2019
Strike	call open interest	put open interest	Cumulative call	Cumulative put loss	Total loss
11000		136125	0	934087500	934087500
11100	225	253650	0	701745000	701745000
11200	6225	232125	22500	494767500	494790000
11300	47175	244575	1267500	311002500	312270000
11400	408000	523050	6030000	151695000	157725000
11500	917100	755850	52192500	44692500	96885000
11600	837975	222975	190065000	13275000	203340000
11700	710325	57675	411735000	4155000	415890000
11800	638325	26850	704437500	802500	705240000
11900	210375	5325	1060972500	135000	1061107500
12000	441450	1350	1438545000	0	1438545000

For above 10 available strikes, we assume market would expire at that point and then compute the Rupee value of the loss for CE and PE option writers. You calculate the total value, we simply have to identify the point at which the least amount of money is lost by the option writer. You can identify this by plotting the ‘bar graph’ of the total value. The bar graph would look like this......

 As you can see, the 11500 strike is the point at which option writers would lose the least amount of money, so as per the option pain theory, 11500 is where the market is likely to expire for the May Weekly series.

Most traders use this max pain level to identity the strikes which they can write. In this case, since 11500 is the expected expiry level, one can choose to write call options above 11500 or put options below 11500 and collect all the premiums.

Suggestion:

To decide the strike for selling is subject question to all, but this theory will make work easy to define and decide the appropriate strike where trader can easily selected with sufficient evidence of open interest with max pain data.

Market may expire below or above the level we decided that time we have to suffer a loss, but it may be very rare if we follow this step continue will come up with conclusion regarding viability of this theory. moreover, one can mix open interest data with this strategy also.

1.      The OI values change every day. This means the option pain could suggest 11500 as the expiry level on 8th of May and may very well suggest 11700 on 15^th of May. I preferred doing this when there were 15 days to expiry but it is well suited for weekly expiry of index. It is very easy to track weekly basis.

2.      I identified the expiry value as per the regular option pain method.

3.      I would add a 4% ‘safety buffer’. So at 15 days to expiry or weekly expiry the theory suggest 11500 as expiry, then I’d add a 4% safety buffer. This would make the expiry value as 11500 + 4% of 11500 = 12000 strike.

4.      I would expect the market to expire at any point between 11100 to 12000.

5.      I would set up strategies keeping this expiry range in mind, my most favorite being to write call options beyond 12000.

6.      writing Put option for this simple belief – panic spreads faster than greed as downside it is always no break with upside there is always a limit to go up.

7.      I would hold the options sold up to expiry, and would usually avoid averaging during this period.

The Put Call Ratio

The Put Call Ratio is a fairly simple ratio to calculate. The ratio helps us identify extreme bullishness or bearishness in the market. PCR is usually considered a contrarian indicator. Meaning, if the PCR indicates extreme bearishness, then we expect the market to reverse, hence the trader turns bullish. Likewise if PCR indicates extreme bullishness, then traders expect markets to reverse and decline.

To calculate PCR, all one needs to do is divide the total open interest of Puts by the total open interest of the Calls. The resulting value usually varies in and around one. Have a look at the image below –

Strike	call open interest	put open interest
11000		136125
11100	225	253650
11200	6225	232125
11300	47175	244575
11400	408000	523050
11500	917100	755850
11600	837975	222975
11700	710325	57675
11800	638325	26850
11900	210375	5325
12000	441450	1350

As on 8^th May, the total OI of both Calls and Puts has been calculated. Dividing the Put OI by Call OI gives us the PCR ratio –

2459550/4217175 = 0.5832

The interpretation is as follows –

If PCR > 1, suggest that there are more puts being bought compared to calls, market is extremely bearish and sort of oversold. any reversals and expect the market to go up.

If PCR < 1, it shows more calls being bought compared to puts, shows extremely bullish and  overbought market, any reversal can tend market to go down.

All values between 0.5 and 1 can be attributed to regular trading activity and can be ignored.

Learning from this theory:

Option Pain theory assumes that the option writers make more money consistently

Option pain assumes that option writers can influence the price of options on the day of expiry.

One can use the theory of option pain to identify strike of the stock/index is likely to expiry.

The strike at which the option writers would experience least amount of loss is the strike at which the stock/index likely to expire.

The PCR is calculated by dividing the Puts by Calls of total interest of both.

The PCR value of over 1.3 is considered bearish and a PCR value of less than 0.5 is considered bullish.

Happy Reading
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