Love Options Selling? Use this Theory for Higher Profits!

Options selling has gradually become one of the most talked-about and probably the most-used way to make money in the stock market, especially by big traders. In a span of 2-3 years, it has become so popular that even newcomers are starting right off the bat with options selling. For the uninitiated, it is simply using various strategies and tactics to short sell options in an attempt to profit from the falling prices.

The underlying assumption in almost all of these strategies is, that even if the view goes wrong, there is still a chance to exit in profit due to theta decay, which to some extent is true. Theta is one of the greeks in an options price that loses its value as time passes by, at an increasing rate. However, if other greeks go against you, they could easily turn a position horribly wrong and sometimes a few months of profits go for a toss with a single gigantic loss.  

As there are many ways to sell options, the most common one is selling on both sides of the market, creating a range, also known as non-directional options trading. The premise of this kind of strategy is that most of the time (famously said to be over 70%) a market is non-trending, especially an index. Therefore, if one sells options both above and below the CMP, at a safer distance he/she might be able to profit from both options. The problem with such a strategy is if the market picks up a direction (on either side) with a sharp move, one side’s loss would easily surpass the other side’s profit (as profit is limited and the loss is unlimited in options selling).

To estimate where the market could finally expire beforehand, which would further lead to better decision-making, there is a theory called the Max Pain theory. The theory states that the market tends to expire at a level that would probably give maximum loss to options buyers. In simple words, if the max pain level for the is 16,500 for the current expiry, it simply means that expiry at this level would give the highest loss to open options positions at this strike price, hence there is a high chance of expiry at 16,500.

Now how to calculate the max pain level? 

First, list down all the strike prices of security under consideration with their open interest (both PE & CE). Then calculate how much money would be lost by the options sellers (both call and put writers) at each strike, assuming the market expires at that strike price. Add the total money lost (in both PEs and CEs). Once you get the loss figure for each strike, the one with the least amount of loss is your max pain level and it is where the market is expected to expire, as it is where the sellers would lose the least and buyers would lose the most.

This level keeps on changing as the CMP and OI keep changing. Therefore manual calculations of these levels are a tedious task and not viable for regular trading, hence there are dedicated options software/platforms that automatically calculate the max pain levels for you.