I mentioned Tuesday in my post about Apple breaking the $100 mark that the rest of the week would be critical for Apple shareholders. Today I’d like to talk about one reason why the rest of the week might end up being pretty boring for Apple shareholders. This reason is also yet another reason round numbers are so tough for stocks to break through.
I don’t talk much about options on this site because I don’t trade options very often. They are extremely risky and volatile, and I see no reason to fool with them unless very specific scenarios play out. There are plenty of people who have extremely complicated option-trading strategies to limit risk. But I always think to myself, “You know what else limits option-trading risk even more than this complicated trading strategy? Not trading options!“
There is an entire chapter in my book explaining what options are and describing the ways I made some of my biggest profits trading options. But for today, I won’t get into too much detail about how options work. I would encourage anyone who is interested to give it a Google. Or just make it easy on yourself and buy my book!
In their simplest form, options are nothing more than contracts to buy or sell shares of stock at a set price on a future date. On that date, if the price is right, you get a good deal buying or selling some stock. If the price is not right, you get nothing, and your option expires worthless. So, since this is Trading Common Sense, I will point out that it should be a matter of common sense that the point of buying options is to not have them expire worthless.
If you are buying call options, you want the stock price to rise above your strike price for that option by the expiration date. That way, you can buy shares of stock at a discount to the market price because of your option contract. If you are buying put options, you want the stock price to fall below your strike price for that option by the expiration date. That way, you can sell shares of stock at a premium to market price because of your option contract.
But there’s two sides to every trade. For every buyer, there is a seller. That’s what makes up the stock market. Every share of stock that is traded represents a piece of a company that was originally sold by that company into the open market via some kind of offering. But where do options come from? These are contracts, so someone must create them before they are sold, right?
Option sellers are called option “writers,” and they are the ones that must honor the contract. For option holders, the writers are the “enemy” because they are the ones that get to laugh their way to the bank when the options expire worthless. “I can’t believe that sucker bought those worthless option contracts from me!” they will say, to which the bank teller will reply, “Sir, I simply asked you to please sign your deposit slip.”
The point is, option writers have a lot to gain from those contracts expiring worthless. Call writers want share prices to fall below the strike price of their contracts, and put writers want prices to rise above the strike price of their contracts. But there is one price at which both calls and puts expire worthless, and that price is the strike price. If a stock closes at a nice round number, such as $100, on an expiration date, all the call options and put options with $100 strike prices that expire on that date will expire worthless. Option buyer loses, and option writer wins.
Of course there are a wide range of strike prices for any given expiration date, but usually there are one or two strike prices that have an exceptional number of option contracts written for them. Since the strike price with the most open contracts is the price at which the stock would cause option holders the largest financial losses, this price is referred to as the “max pain” price.
The idea behind the “Max Pain Theory” is this: as option expiration approaches, option writers will try to buy or sell shares of stock to drive the price toward a closing price that is profitable for them, or at least to hedge their payouts to the option holders. You have call writers selling shares to drive the price down and put writers buying shares to drive the price up, and at the center of the chaos is the max pain strike price itself.
Essentially, all of this buying and selling “funnels” the share price toward the max pain strike price on expiration dates.
For example, Apple closed yesterday at $100.57. By taking a look at Apple’s option spreads for this Friday, it’s easy to see that the highest combined open interest (puts plus calls) for this Friday (August 22) is for a strike price of $100. Therefore, it wouldn’t be surprising if Apple toes the $100 line for the rest of the week and ends up “pinned” very near $100 at the end of the trading day on Friday.
However, since there’s more to max pain than just the highest open-interest strike price. The option writers’ payouts on all the other strike prices have an effect on the max pain.price as well. That being said, the true max pain price for Apple tomorrow is not currently $100, it’s $98.
The numbers across the bottom represent the various strike prices of the stock options. Max Pain is calculated for each strike by determining the cash value paid out on each call and put option at that strike. The red vertical bar is the put option cash value. The green vertical bar is the call option cash value. The further away the stock price is from the max pain point the more the option writers will have to pay out. Conversely, the closer to the max pain point the stock price is the less they pay out.
I don’t believe that the Max Pain Theory or “pinning” is a short-term trading strategy that can be relied on consistently. However, I’ve seen stocks close the week right on round numbers too many times for it to be a coincidence, and it does seem as though certain round numbers have a magnet-like pull on share price during the last hour of trading on Friday afternoon.
Want to learn more about why stock prices move the way they do? Or maybe you just want to be able to look sophisticated in front of your coworkers when they ask you what you are reading on your Kindle, and you’d prefer to tell them “Oh, I’m just reading a book about stock market analysis,” rather than the usual “Oh, I’m just looking at pics of my ex-girlfriend on Facebook.” For these reasons and more, check out my book, Beating Wall Street with Common Sense. I don’t have a degree in finance; I have a degree in neuroscience. You don’t have to predict what stocks will do if you can predict what traders will do and be one step ahead of them. I made a 400% return in the stock market over five years using only basic principles of psychology and common sense. Beating Wall Street with Common Sense is now available on Amazon, and tradingcommonsense.com is always available on your local internet!