People bring up the topic of pain often in crypto. But what does it mean, and how can you use it to your advantage?
Max pain is the financial situation that is looked at from the perspective of option sellers or writers. It is determined based on the volume of open interest at different strike prices of live option contracts.
Max Pain Theory
Max Pain Theory states that the market will gravitate toward the strike price towards expiration. This will cause most calls and puts to expire worthless.
It comes from incentivizing large options sellers to push the stock price in a way options expire worthless, which results in a maximum loss for options buyers and profit for the sellers. The language has spread to broader markets since markets often feel like a zero-sum game.
As per this theory, there is one strike price, which is called, the max pain price, at which the maximum number of call and put writers have built up their positions. They will have maximum pain of loss if the stock expires away from that strike price.
This theory behind Max Pain seems to stem from two main points, namely:
Crowded trades are ripe for others to take advantage of
Markets are designed to cause the maximum amount of pain to investors
Only a few people will make returns above the average yearly rate of index funds. The exorbitant returns of the few that make it come from the many who lost money along the way.
Is Max Pain Down Only?
Not necessarily because when the market dumps enough, you, as a holder, already burn. Short interest usually increases when the market is in the wrong spot.
Here is an example from GMX that shows this action;
Since ETH dropped from around $1.6k to $1.1k due to the FTX news, ETH's shorts on GMX have been 2x the long side until the January rally. Shorters are rekt while more sidelined. After the pump, longs are currently outpacing shorts.
In this situation, the path of Max Pain is no longer down only. But instead of pumping the market and leaving you sidelined, wait for them to FOMO back in at higher prices. And crash the market again, leaving more people to lose money—a prime example of a bear market.
Benefits of Max Pain Theory
Max Pain theory offers a framework where you can see the overcrowding of a trade. You can think about scenarios that cause the most amount of pain to retail traders.
You can use the mentality to add onto positions during long periods of consolidation after an extensive market downturn and take profits when sentiment starts to get irrational.
Max Pain can help you plan out potential scenarios when feeling bullish or bearish. You can use tools like open interest and sentiment analysis. This is to plan out what you think is the best way to be positioned.
Conclusion
Understanding Max Pain gives you intuition on retail positioning and how to protect yourself best. Crypto is PVP, and most people who enter will lose money. Understanding that concept will allow you to understand why specific contrarian trades work.
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