The “Max Pain” theory, also sometimes called “Option Pinning” refers to price action of the underlying stock(s) as they come into options expiration. Price action is pulled to and pinned at a particular price like a magnet - This price is usually the option strike with the highest open interest. Some consider this phenomenon to be total nonsense and sorcery - However, those that have spent enough time watching financial markets have likely witnessed this type of price action a time or two.
Why does it happen?
Certain traders (market makers) have a large incentive to keep a stock near a certain price at the time of an option’s expiration. According to the theory, this is due to the tendency for the price of a underlying stock to gravitate towards its "maximum pain strike price" -- the price where the greatest dollar value of those options will expire worthless. Max pain assumes the option with the highest open interest has the highest number of options traders who are long that option, and who will lose the most amount of money (experience the max amount of pain) if the stock settles at that strike price at expiration. The theory stems from the idea that many market makers and institutional traders are short the options that retail investors and traders are long. So these options shorts have a strong incentive to pin the underlying stock near a particular strike price.
For example, if you are a $NFLX put seller and you have some seriously large size on, when option expiry rolls around you will have an incentive to buy the stock to keep it above the short-put strike price. Same is true and occurs with short calls. In this scenario, calls / puts that the option writer (option seller) has in-the-money (ITM) is a bad thing. Ideally the seller wants these contracts to expire out-of-the-money (OTM) so that they become worthless at expiry. This means the seller collects the entire premium with no risk of shares being assigned.
The Max Pain graph for $NFLX, 5/17/19 expiration
In the graphic above, we can see the dark-blue line highlighting the 355 strike for the 5/17/19 monthly options expiration (monthly-opex). The bars indicate how much money would be paid out if the stock were to close at the strike price. The light blue bars is the money paid out on puts. The purple bars is the money paid out on calls. At the max pain price of 355, the least amount of options will be paid out.
what does this mean for retail options traders?
While options traders do witness this type of action on a regular basis with monthly expiring options, it is important to note that it doesn’t happen with any consistency. You can see option pinning on a particular stock for a period of time and then it stops. For this reason, we do not base any strategies or trades around option pinning / max pain theory. That being said, option pinning and max pain theory are worthy of consideration when beginning your trading day on a monthly-opex Friday. After the morning session is complete and mid day lull starts to begin, keep your expectations in line. Always remember that the underlying stock you’re watching could very well end up being pinned and trade in a very tight range through the afternoon and into the end of the trading session.