Using Option Pain (Max Pain) to estimate stock price

While the market is sorting things out today, I'd like to document a simple stock price predictor based on put/call activity called Option Pain or Max Pain.

It is widely believed that professional traders favour writing options. Since trading options is a zero-sum game, it is in their best interest if a majority of options expire worthless on expiration day.

By observing the open interest of a stock at each strike price, we can see at what price the Option Pain would occur. Of course, this is just another tool for the trader to use, so do your own due diligence as usual when trading.

[caption id="attachment_500" align="aligncenter" width="500" caption="SLW Nov08 Max Pain"][Nov '08 SLW Option Pain][][/caption]

Using this chart from Option Pain, we can see that the minimum option total value of November SLW is at \$5. So our max pain price is at \$5 for November's SLW. That is to say, if SLW settles at \$5, then the most call option would expire worthless and most of the put option would expire worthless. Such that the option sellers (the pros) can pocket your money.

Another way to use this information is to find the best Max Pain to Current Price ratio among a list of stocks. For example, SLW closed at \$2.59 yesterday. Its max pain is \$5 from the chart above. That is almost a double. Note, however, that we haven't figured out the probability of SLW reaching \$5. This would be something for me to look into.

In comparison, GOOG's max pain for November is at \$360. Its previous closing price is 329.49. Based on these numbers, SLW is a better buy than GOOG for now.

[Nov '08 SLW Option Pain]: http://traderpau.files.wordpress.com/2008/10/slw-optionpain.jpg