April 2021 | Victoria Bogner, CFP®, CFA, AIF®
This month instead of a standard commentary, I’m going to teach you a little something about the stock market. This is a peek behind the curtain of a phenomenon that happens every single month and how it affects the stock market at large. I’m going to talk about the max pain theory. But first let me define a few terms.
An option is a contract that gives the buyer the option to buy or sell a specific asset at a specific price within a specific timeframe. Call options allow the holder to buy an asset. Put options allow the holder to sell an asset. For every option, there’s someone that writes the contract and someone that subsequently buys that contract from the writer for a cost. The cost is determined by the price of the asset at the current time and how volatile it is. The more volatile the price of the asset, the more expensive it is to buy an option on it.
Here’s an example of a common options strategy. Suppose you own 100 shares of the fictional Acme stock, which is trading for $50/share. The price doesn’t move around a lot, and you’d like to make some additional money on the side. You decide to write a call option that gives someone the right to buy 100 shares of Acme stock from you for $52/share. The option is good for 30 days and can be sold for $25.
Someone buys the call you’ve written and gives you $25 for it. You’re now $25 richer. For the buyer, they need the stock price to go higher than $52.25 to exercise the option and make more than what they paid you.
Now let’s say that within 30 days, the stock price goes to $53/share. The buyer decides to exercise their option and you must hand over your shares at $52/share. But if after 30 days the share price remains below $52.25, the option expires worthless, you get to keep your stock, and you made $25 on the side.
On the other side of the coin, someone could write an option to allow someone to sell Acme stock at $48/share. If you want to protect yourself from a possible crash in the Acme share price, you may want to pay $25 as insurance against that. If the share price goes down below $47.75/share before the option expires, you can sell your shares to the option seller for $48/share. If the stock price never goes down that far, the option expires worthless and you’re out $25.
Ok, that was a crash course on options. Now for the real lesson.
Every third Friday of the month is known as options expiration day for that month. As time draws closer to this particular day, there are many options that are worth exercising and many options that are about to expire worthless. Institutional investors with billions of dollars at their disposal use options as a hedge and also use them to make additional money on the side. These institutional investors don’t want to lose money however, so they use the power of their capital to bend a stock price to their will (as much as they can). For some, this means buying massive amounts of a stock in which they have call options in hopes of moving the stock price higher. For others, this means selling massive amounts of stock in which they have put options in hopes of moving the stock price lower. Think of it like a gigantic tug of war with billions of dollars on either side.
There is a price of any asset which is called the “max pain” price. This is the price at which the aggregate of option owners experience the most monetary loss. Max pain theory posits that as options draw closer to their expiration date, asset prices tend to move toward their max pain price. Here’s an example of this from this month. I’ve blurred the stock ticker since I don’t want to construe that I’m recommending anything.
On March 16th, we were eight trading days away from the options expiration of this asset. Calculating the max pain price yielded the green line you see on the graph below. The price of this asset was trading 3% above that price on the 16th.
According to the max pain theory, the price should gravitate toward the price of maximum pain for options investors as expiration of the options draws nearer. In this case, that happened within 3 days:
When analyzing the stock market and asset movement, I always take this phenomenon into account. Does this perfectly predict an asset’s price movement? Not at all. It’s merely one of the tools we have in our toolbox to determine what’s moving the market and why. We look at an abundance of mechanisms to determine what creates a market’s trend. It’s complex and the average investor doesn’t know what to look for. That’s one of the reasons many clients trust us and our knowledge to manage their accounts for them.