Reading Market Sentiment with Max Pain and PCR

Understanding Max Pain

Max Pain, also called Option Pain, is one of the more debated concepts in options trading.

The theory is based on the idea that option buyers and sellers participate in a zero-sum market: what one side gains, the other side loses.

The theory further assumes that option writers tend to make money more consistently than option buyers.

From this assumption, the theory tries to identify a price level at which option writers would experience the least amount of loss.

That price is referred to as the Max Pain level.

The Logic Behind Option Pain

The theory follows a chain of assumptions.

If option sellers tend to make money more consistently, the theory reasons that:

1. Option sellers are generally the profitable side.
2. The expiry price should therefore be at a level that causes the least loss to option writers.
3. If such a price can be identified, it may provide an indication of where the underlying could expire.
4. This level can then be called the Option Pain or Max Pain level.

The theory therefore attempts to answer a simple question:

At which strike would option writers collectively experience the least amount of loss at expiry?

An Important Limitation

Max Pain should not be treated as a guaranteed expiry prediction.

The source itself presents Option Pain as a controversial theory and explains that the author's own experience with it was mixed.

The calculated Max Pain level can change as open interest changes.

Therefore, a Max Pain level calculated today may not remain the same closer to expiry.

This is an important reason to treat the concept as an analytical reference, rather than a certainty.

How Is Max Pain Calculated?

The calculation is based on the Open Interest (OI) of Calls and Puts at different strikes.

The basic process can be broken into steps.

Step 1: List the Strikes

Start by listing the different option strike prices available on the exchange.

For each strike, record:

• Call Open Interest
• Put Open Interest

Step 2: Assume Expiry at Each Strike

Now take one strike at a time.

For example, assume:

"What if the underlying expires exactly at this strike?"

Repeat this calculation for every relevant strike.

This allows you to determine the total loss that option writers would experience if expiry occurred at each possible price.

Step 3: Calculate the Option Writers' Loss

For every assumed expiry level, calculate the intrinsic value payable on the outstanding options.

The losses from Calls and Puts are then added together.

The process is repeated for all the strikes.

The strike producing the lowest total loss for option writers becomes the Max Pain level.

A Simple Illustration

Suppose the calculations produce the following results:

In this simplified example:

Max Pain = 7,800

According to the theory, 7,800 would be the level where option writers experience the least amount of loss.

The source gives an example where 7,800 was identified as the level at which option writers would lose the least amount of money.

How Can Max Pain Be Used?

Once a Max Pain level is identified, traders may use it as a reference for option-writing strategies.

For example, if the calculated Max Pain level is 7,800, one possible approach described in the source is:

• Write Calls above 7,800
• Write Puts below 7,800

The underlying assumption is that the market may gravitate towards the identified expiry level.

However, this should not be interpreted as a guaranteed strategy.

The Max Pain level itself can change as market positioning changes.

Why Max Pain Can Change

Open Interest is not fixed.

Traders continuously:

• Open new positions
• Close existing positions
• Roll positions
• Shift positions between strikes

As a result, the OI distribution changes.

Since Max Pain is calculated from OI, the calculated Max Pain level can also change.

For example:

10 May → Max Pain = 7,800

20 May → Max Pain = 8,000

Both calculations can be correct for their respective dates because the underlying option positioning has changed.

A Practical Modification

The source describes a personal modification to the standard Max Pain approach.

The process involved:

1. Fixing a particular day to calculate Max Pain.
2. Doing this approximately 15 days before expiry.
3. Calculating the regular Max Pain expiry level.
4. Adding a 5% safety buffer.
5. Treating the expected expiry as a range rather than a single number.
6. Using the range to determine option-writing opportunities.

For example, if Max Pain indicated 7,800, adding a 5% buffer produced approximately:

7,800 + 5% = 8,190

This was rounded to approximately 8,200.

The expected expiry range was therefore considered to be roughly:

7,800 to 8,200

Why Use a Range Instead of a Single Price?

Markets rarely move according to an exact number.

Even if Max Pain suggests a particular expiry level, the underlying can expire meaningfully above or below that level.

Using a range therefore provides some flexibility.

The source describes using the range to identify strikes for option writing rather than assuming that the market must expire exactly at the calculated Max Pain value.

Why Avoid Writing Puts in This Approach?

The source describes avoiding Put writing as part of this particular modification.

The reasoning given is:

Panic spreads faster than greed.

In other words, markets can sometimes fall much faster than they rise.

Therefore, writing Calls beyond the upper end of the expected expiry range was preferred over writing Puts below the lower end.

This is a specific risk-management preference described in the source, rather than a universal rule for all traders.

Introducing the Put-Call Ratio

The second major concept in this chapter is the Put-Call Ratio, commonly called PCR.

PCR is a simple ratio that compares:

Put Open Interest

with

Call Open Interest

Formula

PCR = Total Put Open Interest ÷ Total Call Open Interest

A Simple PCR Calculation

Suppose the total Open Interest is:

• Put OI = 37,016,925
• Call OI = 42,874,200

Then:

PCR = 37,016,925 ÷ 42,874,200

PCR ≈ 0.86

This is the example provided in the source.

How Is PCR Interpreted?

PCR is generally interpreted as an indicator of market sentiment.

The source treats it primarily as a contrarian indicator.

This means that extreme readings can potentially signal that the market has become excessively bullish or bearish.

The basic idea is:

Extreme bearishness → Look for possible bullish reversal

Extreme bullishness → Look for possible bearish reversal

High PCR

A high PCR indicates that Put Open Interest is relatively large compared with Call Open Interest.

The source gives 1.3 as an example of a high PCR.

A value around or above this level can indicate extreme bearishness.

From a contrarian perspective, excessive bearishness may suggest that the market is oversold and could potentially reverse upward.

Therefore:

High PCR → Extreme bearishness → Possible bullish reversal

Low PCR

A low PCR indicates that Call Open Interest is relatively large compared with Put Open Interest.

The source gives 0.5 and below as an example of a low PCR.

This can indicate extreme bullishness.

From a contrarian perspective, excessive bullishness may suggest that the market is overbought and could potentially reverse downward.

Therefore:

Low PCR → Extreme bullishness → Possible bearish reversal

What About PCR Between 0.5 and 1?

The source suggests that values between approximately 0.5 and 1 can generally be treated as normal trading activity.

Such readings do not necessarily represent extreme sentiment.

Therefore, the focus is primarily on unusually high or unusually low readings.

Why Is PCR Considered Contrarian?

The reasoning is based on positioning.

Suppose traders become extremely bearish.

Many traders may already have taken bearish positions.

If most of the market is already positioned in one direction, there may be fewer participants left to create another strong move in that same direction.

Eventually, these positions may be closed.

This can contribute to a move in the opposite direction.

The same logic applies when the market becomes extremely bullish.

This is the basic reasoning behind using PCR as a contrarian indicator.

Why Historical Comparison Matters

A single PCR number should not automatically be interpreted as extreme.

The appropriate level can differ between:

• Different indices
• Different stocks
• Different market conditions

For example, a PCR of 1.3 may represent extreme bearishness for one underlying, while another underlying could normally trade around a different range.

The source therefore suggests historically plotting PCR values and identifying what constitutes extreme readings for the particular underlying.

Backtesting can help establish these ranges.

Max Pain vs PCR

Although both concepts use option-market data, they answer different questions.

They can therefore be studied together, but they should not be confused with one another.

Important Practical Caution

Neither Max Pain nor PCR should be treated as a standalone prediction tool.

Max Pain depends on changing Open Interest.

PCR can also change as traders alter their positions.

Therefore, these indicators are better understood as additional information about market positioning, rather than guaranteed signals.

The source's own discussion of Max Pain highlights how the calculated level can change and how practical modifications were required to make the approach more suitable for risk management.

Key Takeaways

1. Max Pain, also called Option Pain, attempts to identify the expiry level that causes the least loss to option writers.
2. The calculation is based on Call and Put Open Interest across different strikes.
3. To calculate Max Pain, assume expiry at each strike and calculate the total loss to option writers.
4. The strike producing the lowest total writer loss becomes the Max Pain level.
5. Max Pain can be used as a reference for identifying potential option-writing levels.
6. Max Pain is not a guaranteed expiry prediction.
7. Because Open Interest changes, the Max Pain level can also change over time.
8. A practical approach described in the source is to use a safety buffer and consider an expiry range instead of a single price.
9. PCR = Total Put OI ÷ Total Call OI.
10. PCR is generally used as a contrarian indicator.
11. A PCR around 1.3 or higher can indicate extreme bearishness and potentially an oversold market.
12. A PCR around 0.5 or lower can indicate extreme bullishness and potentially an overbought market.
13. PCR values between approximately 0.5 and 1 can generally represent regular market activity.
14. Historical PCR data is useful because the level representing "extreme" sentiment can differ across underlyings.
15. Max Pain and PCR should be treated as market-positioning tools, not as guaranteed trading signals.