Open Interest, Max-Pain
Theory, and Pinning
BIG IDEA: YOU MAY HAVE HEARD THESE THREE PHRASES.
BUT WHAT DO THEY HAVE TO DO WITH EACH OTHER?
LET’S TAKE A CLOSER LOOK.
• ON THE TRADING FLOOR, you didn’t
need to think much about an option’s open
interest. Market makers are ready to buy
when you want to sell, and sell when you
want to buy. And while that was going on,
somebody at the exchange was busy calculating the open interest.
Open interest represents the total number of
open option contracts traders have in their
accounts. For example, if you buy one XYZ
$50 call, and a market maker sells you that
call, the open interest in that call is one (
assuming no one else has yet traded the call).
If you buy another XYZ $50 call, and the
market maker sells it to you, the open interest on that call rises to two. If you sell one
of those XYZ $50 calls back to the market
maker, the open interest on the call drops to
one. And should you sell the other XYZ $50
call, its open interest drops to zero. But with
thousands of options traded, open interest
gets a bit harder to calculate. That’s why the
exchanges do it, not veteran floor traders.
Market makers noticed that sometimes on
expiration Friday, a stock’s price gets pulled
toward the option strike with the highest
open interest. Drawn like a magnet. It could
even “pin” there—the term used when a
stock price settles at, or very close to, a strike
price at expiration. Of course, a stock can
also pin at a strike price by random chance.
With so many stocks’ options having one-point strike intervals, it’s not unusual to see a
stock’s price pin. But when you see the same
stock do it expiration after expiration, you
begin to wonder what might be behind it.
OH, THE PAIN …
Enter “max pain theory,” which states that
a stock price will move toward an option’s
strike price with the highest open interest at
expiration. Why max pain? Most retail investors buy options. If the stock price closes
exactly at an option’s strike price at expiration, the option will be worthless. Max pain
assumes the option with the highest open
interest has the highest number of investors
who are long that option, and who will lose
the most amount of money (experience the
max amount of pain) if the stock settles at
that strike price at expiration.
Remember, max pain is a theory that
stems from the idea that many professional traders are short the options that retail
investors are long.
Stocks may show this pinning/max pain
action for a while, then stop. It’s not consistent, so it’s hard to base a trading strategy
Open interest can be best used as a proxy
for liquidity, or for analyzing how e;cient it
is to execute trades. Combined with high volume, high open interest means a lot of people
are trading that option. And that means you
may try to enter a limit order in between the
posted bid and ask price to try to get a better
fill. Over time, getting better fill prices can
mean lower execution costs, which is a good
thing in any stock or option.
Thomas Preston is not a representative of
TD Ameritrade, Inc. The material, views, and
opinions expressed in this article are solely those
of the author and may not be reflective of those
held by TD Ameritrade, Inc.
For more on the risks of trading and trading
options, see page 37, #1– 2. Past performance of
a security, strategy, or index is no guarantee of
future results or investment success.
To display open
interest on your
charts, head to