How Painful is the Maximum Pain? Important Things Before the Options Settlement Date

2021-05-28, 10:47

According to publicly available data from Skew Analytics, May 28th is the expiration date for cryptocurrency options. At that time, more than 55,000 bitcoin options with a total value of $2.2 billion will expire. The max pain for this expiration of bitcoin options is $50,000, which is 25% higher than the price of today according to calculations by related agencies.

Understand the Maximum Pain, You Must First Understand Options

In traditional financial markets, options are an option derived from futures, which can be considered as a right to be able to buy or sell a specific amount of a specific commodity at a specific price at a specific time in the future. The option holder can choose to exercise his right to buy or not to buy, or to sell or not to sell, at a specified time after paying a margin. And the holder can also waive that right.

Data source: TradeBrains.in

There are usually two types of options, call options and put options, depending on the rights of the option.

A call option means that the buyer, by paying a certain amount of margin to the seller, has the right to buy a certain amount of a specific commodity specified in the contract from the option seller at a pre-agreed price during the term of the option contract, but does not assume the obligation to buy. The option seller, on the other hand, is obligated to sell the specified commodity at the specified price at the buyer’s request during the term of the option. The buyer at this time is long in the contract.

Put options are options where the buyer, by paying a certain amount of margin to the seller, has the right to sell a certain amount of a specific commodity specified in the contract to the seller at a pre-agreed price during the term of the option contract but does not have the obligation to sell. The option seller, on the other hand, is obligated to buy the specified commodity at the specified price at the buyer's request during the term of the option. The buyer at this time is in a short position in the contract.

In both types of options, the buyer has the right to choose not to buy or sell. However, the margin they paid to the seller in advance is then fully collected by the seller, as profit.

Options are mainly used in the traditional financial, including ETF options, agricultural options, precious metal options, original options, etc. With the exponential growth of cryptocurrency, market trading, ordinary spot trading, leveraged ETFs, etc. can no longer meet the needs of some traders, and major exchanges have gradually opened up options trading on certain cryptocurrencies such as bitcoin.

Simple Examples of Bitcoin Futures Trading

Take a bitcoin call option as an example; Supposing on June 1, the buyer buys a bitcoin call option contract from the seller for $1,000 with a strike price of $40,000, and an expiry date of June 30. The bitcoin price on that day ends up being $30,000.

Scenario 1: On June 30, the price of bitcoin rises to $45,000 and the buyer exercises their option, at which point the total gain is $5,000, a 500% return.

Scenario 2: On June 30, the Bitcoin price drops to $20,000 and the buyer chooses not to take the option and gives up $1,000 as margin for a return is -100%.

How Painful is the Maximum Pain?

“Maximum Pain” is the price at which the option expires with the least amount of profit for the buyer or the least amount of profit for the seller. The “pain” is for the buyer. However, since the max pain level changes over the expiration of the option as the position and the strike position change, the level at which Max Pain is located of most interest when it is close to the settlement date. The point of max pain is calculated for all holders (buyers) and has no relation to the position of individual traders.

When calculating the max pain, you need to first select the strike price and assume that all current open positions settle at this selected strike price and calculate the intrinsic value of each option contract. Assuming there are currently $35,000, $37,000, and $39,000 bitcoin option strike prices in existence and assuming a settlement price of $37,000, the intrinsic value of all option contracts is calculated in turn. The buyer’s option “max pain” is the strike price with the lowest number.

According to calculations by bitcoin options futures exchange Deribit for the 48,469 bitcoin options contracts and 307,558 ethereum options contracts due to expire on the last Friday of May, the max pain for bitcoin this time is $50,000, a 36% difference from the price of $36,647 at the time of writing, and the max pain point for ethereum is $3,000, a 17% difference from the price of $2552.4, a difference of 17%.

Data source: Deribit Twitter

Reference Significance of the Maximum Pain

Options trading has a delivery deadline. Usually, the closer you get to the delivery date, the more interested option traders will be in the market price. Max pain will be more clear as the deadline approaches.

Since the right to exercise the option is in the hands of the buyer, the seller has a more passive role. When the price at delivery favors the buyer, the seller needs to bear the corresponding loss. Therefore, as sellers of options contracts, they may prefer to keep the price close to the max pain before the settlement date in order to ensure they receive maximum profit. The closer the price is to the max pain, the more likely it is that the buyer will choose to forgo the margin in order to protect themselves from significant losses. In this way, the seller will be able to almost guarantee their profit.

For the buyer, the max pain can be used as a point of reference. If, close to the expiry date, the current price is above the max pain, then the buyer can choose to buy the current price at the max pain as a put option. If the current price is below the max pain, the buyer can choose to buy a call option.

Gate.io has launched a warrant trading testnet and dual currency product similar to the principle of options trading for the convenience of its users. Come explore now!

Gate.io Cryptopedia for Reference:
Introduction to Short-Term Options

Author: Gate.io Researcher: Gazer.C Translator: Lexie.L
* This article represents only the views of the researcher and does not constitute any investment suggestions.
*Gate.io reserves all rights to this article. Reposting of the article will be permitted provided Gate.io is referenced. In all other cases, legal action will be taken due to copyright infringement.

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