Pinning Down Max Pain Theory

On Wednesday, I wrote about the Maximum Pain Theory  and the role it plays in share price movement.  The main idea is that the actions of option writers drive share prices toward nice, round numbers, or the “max pain” strike price.

The example I looked at was Apple, which, after breaking above $100 for the first time since it’s stock split earlier this year, has seemed to be “stuck” right around that level all week. I predicted that, because of the large number of outstanding Apple options with $100 strike prices, “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.”

Again, this prediction is based on the Maximum Pain Theory of stock trading. But is there any solid, definitive evidence that this theory works? Ummmmm…. not really. So why the hell would I bother wasting time writing about it?

First of all, I find it interesting. Because I’m a dork. But secondly, the stock market is not a laboratory. There are no laws that dictate stock price movement, only ideas that do so. And the beautiful thing about these ideas is that they don’t have to be true for people to believe them. And, taking that thought a step farther, these ideas don’t have to be true to work!

If I’ve said it once, I’ve said it a thousand times: the only real thing that moves share price is buyers and sellers. If you want to make money in the stock market, you need to buy stocks that others will be willing to buy at higher prices. And while it’s always nice for a stock to rise because of something good that the company is doing, the money is just as green if the share price rises because other traders are stupid.

I don’t mean to imply that people that trade based on the Max Pain Theory are stupid. I myself have traded based on this idea, or at least a spin-off of this idea. I don’t necessarily believe that the Max Pain Theory by itself has much predictive power, but the fact that I see this theory popping up so much in certain Stocktwits ticker feeds every Friday tells me that  there are many traders out there who do believe in Max Pain Theory.

In that sense, Max Pain Theory can be yet another example of a self-fulfilling prophesy. It doesn’t matter if the theory actually works, if traders believe it works, they will buy and sell as if it were true. And that buying and selling will drive the share price.

Certain stocks are more susceptible to the buying and selling of… naive traders than others. Apple is a very popular stock. Everyone is familiar with the company and its products, it is always getting air time on CNBC, and everybody seems to own at least one Apple product. Stocks such as Apple, Google, Twitter, Bank of America, Netflix, World Wrestling Entertainment, Amazon, Ebay, and Citigroup tend to appeal to new and inexperienced investors because they are popular, recognizable stocks. And before I get angry emails from shareholders of these companies, I have positions in three of them myself! There is a difference between owning a popular stock and owning a stock because it’s a popular stock.

So I’ve observed that Apple is a stock that seems to end up “pinned” a lot of the time at the end of the week. Is this because the Max Pain Theory works? Or is it because Apple traders believe it works? I dunno. I really don’t care. Either way, the result is a week like this week, when Apple broke out above $100 for the first time this year on Tuesday, only to remain “stuck” there and finish the week at $101.37.

Monday might tell the tale of where Apple shares will be moving in the weeks to come, but for now Apple shareholders like me will be celebrating our first triple-digit weekend of 2014!

Want to learn more about the psychology of the stock market? 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 SenseI 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 is always available on your local internet!