Have you ever heard statistics like ‘85% to 90% of all options contracts expire worthless’? It’s not true. In fact, a comprehensive study that included more than thirty years of data showed that only 30% of options expire worthless. Roughly 10% of all options contracts are exercised and the remaining 60% are closed through offsetting transactions (statistics presented at Oasis 2004 by Alex Jacobson, Vice President, International Securities Exchange.) Nevertheless, a large number of options do expire worthless and the Maximum Pain Theory holds that the price of the underlying asset will gravitate towards the price where the greatest number of options will expire worthless. This article takes another look at the theory using the Semiconductor HOLDRS (SMH) as an example.
According to the theory of maximum pain, the underlying stock or index will tend to move towards the price where the greatest numbers of options contracts (in dollar value) will expire worthless. It is the point where option owners feel the maximum pain and option sellers reap the most reward. Whether some sort of market manipulation or mere chance causes this to occur is subject to debate, but there is some evidence that the tendency exists. It seems to occur more predictably when there are no major news stories or other market moving events that can otherwise cause a sudden movement in the underlying asset. So, you might think of that maximum pain point as the path of least resistance.
In order to compute the maximum pain price, or the price level that will see the greatest number of options expire worthless, one has to compute the dollar value of all open contracts. Let’s consider an example using the Semiconductor HOLDRS and the December options, which expire in just four more days. The open interest data is from Monday, December 12. The first step is to look at the open interest across all December options. See table 1.
Call Open Interest
Put Open Interest
Table 1: SMH December Put and Call Open Interest
After gathering all of the strike prices and open interest numbers for the December SMH options, the next step is to compute the cumulative value of the open interest for both the puts and the calls assuming the Semiconductor HOLDRS closes at various prices. Here will assume that, at expiration, the SMH closes at a value equal to each of the nine strike prices. The process is done for both the puts and the calls.
For example, if the Semiconductor HOLDR closes Friday trading at 30, the value of all the in-the-money CALL options is $384,500 [or (2.5 x 1402 x 100) + (5 x 68 x 100)]. This is the value of the options that will NOT expire worthless if the SMH is at $30.00 at expiration. It is computed as the difference between the price of the SMH (30 in this example) minus the strike price of the in the money option, times the open interest. From table 2 we can see that the cumulative dollar value of the calls increases as the SMH moves up in price, but the value of the puts declines as the Semiconductor HOLDRS moves higher.
Total Value of Calls
Total Value of Puts
Table 2: Total $ Value of Puts and Calls
The third step in finding the point of maximum pain is to add the total value of the open interest for both the puts and calls across the various prices. In table 3, the total value appears in the last column. The point of maximum pain occurs where the total value is the least. At that level, the most puts AND the most calls will expire worthless, causing the most pain to option owners. In our example, $37.50 represents the price of maximum pain. (Note: 37.5 makes sense when looking back at table 1 because at that level, more than 117,000 put options and 57,000 calls expire worthless. Figure 1 shows the point of maximum pain graphically.
Total Value of Puts and Calls
Table 3: Total Value of puts and calls
In conclusion, the maximum pain theory suggests that SMH could see weakness heading into December option expiration. Recently, the fund traded near $38.25 a share and the point of maximum pain sits at $37.50 a share. Of course, as noted earlier, the price of maximum pain could change as options traders buy and sell options today and later this week. The open interest will change. In addition, December option expiration is also a triple witching—which is the quarterly expiration that involves futures, futures options, and stock options. Therefore, trading could be more volatile leading up to Friday’s expiration and cause wide price movements in the SMH and throughout the rest of the market.
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