What is Max Pain and PCR ratio?

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Considering the fact that we spent the last 9 chapters trying to understand the different options strategies, let’s take a break and digress a little, shall we? In this final chapter of the module, we’re not going to be dealing with options strategies, but rather, with two concepts that are integral to the options theory - max pain and PCR ratio. Options traders tend to constantly keep an eye on these two metrics, mainly because these numbers can give traders some deep insights into the market movements. So, let’s kick off this final chapter with the concept of max pain.

What is max pain?

Max pain is the strike price of an asset where the total number of open contracts, which includes both put option contracts and call option contracts, are the highest. Since max pain is essentially just a particular strike price of an asset, it is also referred to as the max pain price by options traders.

Here’s something that you should know. The concept of max pain is derived from the ‘maximum pain theory’. This theory essentially states that option buyers who hold their option contracts till the expiration date will almost always lose money. We’ll go into more detail in the forthcoming segment of this chapter.

Option traders consider max pain a very significant metric. One of the reasons for that is the fact that the max pain price is also the strike price at which the maximum number of option buyers are likely to experience losses on option expiry day.

What is the max pain theory?

The maximum pain theory is a relatively new theory that came into existence somewhere around the year 2004.

This theory basically states that as the options expiry date comes closer, the price of an asset would always tend to move towards a strike price where the maximum number of options would expire worthless.

And that this particular strike price would be the maximum pain strike price, since it would cause the maximum amount of pain (read losses) to the maximum number of options buyers.

As you’ve already read above, the max pain theory also states that the option buyers who hold onto their contracts till expiry will lose money. The reason for that can be attributed to the fact that option sellers typically hedge their positions, whereas option buyers don’t.

Here’s an example. An option seller who has sold call options of a particular company, would sell the shares of the said company in a bid to drive the price down so that the trade becomes favourable for them. Similarly, an option seller who has sold put options, would buy the shares of the company to drive the price higher so that the trade becomes favourable.

On the other hand, an option buyer would generally choose not to hedge their position since the maximum amount of loss for them is restricted to the premium paid for the contract.

The inaction on the part of the option buyers combined with the buying and selling of shares by option sellers tends to skew the price movement of the asset in favour of option sellers as the expiry date comes closer. This skewed price movement in favour of option sellers is what would ultimately lead to the max pain strike price on expiry.

What is the PCR ratio?

Also known as the Put-Call ratio, the PCR ratio is basically an indicator that allows traders to gauge the market sentiment to determine whether it is bullish or bearish. Determining the PCR ratio is quite easy. Here’s what you would need to do.

PCR ratio = Total number of traded puts ÷ total number of traded calls

A put-call ratio of 1 denotes that the number of traded puts and the number of traded calls are equal. On the other hand, a PCR ratio of less than 1 would mean that the number of calls are higher than the number of puts. This indicates a bullish market sentiment. And, a PCR ratio of higher than 1 means that the number of puts are higher than the number of calls. Such a scenario indicates a bearish market sentiment.

However, the put-call ratio is generally viewed by traders as a contrarian indicator. What this essentially means is that, if the PCR ratio denotes a bearish market sentiment, then the chances of the market reversing into a bullish trend becomes higher. And so, this ratio should be viewed as an indicator of impending reversal from the current market sentiment.

Here’s an example that can help you better understand the PCR ratio.

Say you wish to invest in an options contract of the State Bank of India. But you’re not sure whether you should purchase a call option or a put option. And so, you set out to determine the market sentiment for this particular stock through the use of the PCR ratio.

Upon examining, you find out that the total number of call options of State Bank of India that were traded stood at 42,31,823. And the total number of traded put options of State Bank of India were 32,07,257. Using the PCR ratio formula, we get the following results.

PCR ratio of SBI = 42,31,823 ÷ 32,07,257 = 1.32

Since the PCR ratio of SBI is above 1 (1.32), it indicates a bearish market sentiment. As a result, the chances of the trend reversing from bearish to bullish is high. Considering this, it may be a good idea to take a bullish view on the stock and purchase call options of State Bank of India.

Wrapping up

With this, we’ve come to the end of this module. Hope you’re now clear on the various options strategies that we’ve gone over. Here’s a tip. Before you actually put an options strategy in motion, always make sure to test it thoroughly under various hypothetical scenarios. This will allow you to get a better idea of what the result would likely be under real-life situations. 

A quick recap

  • Max pain is the strike price of an asset where the total number of open contracts, which includes both put option contracts and call option contracts, are the highest.
  • It is also referred to as the max pain price by options traders. 
  • The max pain price is also the strike price at which the maximum number of option buyers are likely to experience losses on option expiry day.     
  • The concept of max pain is derived from the ‘maximum pain theory’. This theory essentially states that option buyers who hold their option contracts till the expiration date will almost always lose money. 
  • This theory basically states that as the options expiry date comes closer, the price of an asset would always tend to move towards a strike price where the maximum number of options would expire worthless.
  • It also states that the option buyers who hold onto their contracts till expiry will lose money. The reason for that can be attributed to the fact that option sellers typically hedge their positions, whereas option buyers don’t. 
  • Moving on to the PCR ratio, which is also known as the Put-Call ratio -  it can be used to gauge the market sentiment to determine whether it is bullish or bearish. 
  • The ratio is calculated using the formula: Total number of traded puts ÷ total number of traded calls
  • A put-call ratio of 1 denotes that the number of traded puts and the number of traded calls are equal. 
  • A PCR ratio of less than 1 would mean that the number of calls are higher than the number of puts, indicating a bullish market sentiment. 
  • A PCR ratio of higher than 1 means that the number of puts are higher than the number of calls, indicating a bearish market sentiment. 
  • Interestingly, the put-call ratio is generally viewed by traders as a contrarian indicator.
  • This essentially means that if the PCR ratio denotes a bearish market sentiment, the chances of the market reversing into a bullish trend becomes higher. 
  • So, this ratio should be viewed as an indicator of impending reversal from the current market sentiment.
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