Max Pain Theory in Practice

Max pain theory is a theory that suggests that the stock price movements are influenced by the options’ expiration. The max pain theory posits that the underlying asset of an option will move in such a way that it causes the most pain to the largest number of option holders.

Reference [1] examined formally the accuracy of the max pain theory and whether it can be a useful tool for traders to use when making decisions about options trading. The paper proved the validity of the max pain theory and showed that one can use it to construct a long/short portfolio that delivers positive and significant returns.

In this paper, we test the empirical validity of the maximum pain theory. We construct a measure of Max Pain and form decile portfolios on the second Friday of each month. We hold the portfolios for one week. We find that a spread portfolio that buys high Max Pain stocks and sells low Max Pain stocks offers very positive and statistically significant returns. We find similar results for alphas.

The authors also found that the max pain portfolios tend to be growth stocks that are small and illiquid.  Furthermore, the trading strategy based on the max pain theory is more suitable for institutional investors than retail investors.

We compute the abnormal stock volume and order imbalances of stocks sorted based on Max Pain. High Max Pain stocks have higher abnormal volume and order imbalances. However, we do not find significant results for retail abnormal order imbalances, implying that this strategy is more relevant for institutional investors.

This article is another interesting addition to the growing body of research on stock options volume and order imbalances.

References

[1] Filippou, Ilias and Garcia-Ares, Pedro Angel and Zapatero, Fernando, No Max Pain, No Max Gain: Stock Price Predictability at Options Expiration (2022). https://ssrn.com/abstract=4140487

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