Prices tend to get drawn toward the option strike with the highest open interest. That means those who are long the option may experience the most pain if the stock settles at the strike price at expiration.
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.
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 around it.
Open interest can be best used as a proxy for liquidity, or for analyzing how efficient 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.
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