Please explain the relevance of Max Pain and Martingale in Option trading
Using Max Pain can help with strike selection. The theory is that option sellers possibly have more capital at their disposal and are more ‘informed’ (institutional traders and market makers). Option sellers will want their contracts to expire worthless and may exert influence on the underlying in order to make that happen. We have UpLearn content about Max Pain here: https://upstox.com/uplearn/options-trading-101/options-terminology/36009-what-is-max-pain/
Martingale is a betting strategy of doubling down on your losses and reducing your winners. It seems natural to want to double down on your losses because it lowers your break even point and may seem like a quick way to “get back to flat”. The theory is based on mean-reversion. For example, if you believe the underlying will go up and you buy a call. If the underlying instead goes down, the call will lose value. With the martingale bet, you would double your position in the call so when the underlying ‘mean reverts’, you will reduce or avoid your loss. There are a few problems with this. 1) There is an old saying: The markets can remain irrational longer than a rational investor can remain solvent. Essentially, mean reversion doesn’t necessarily happen on your timeline. The option could expire worthless before the underlying mean reverts. 2) Doubling down on losing positions could work in your favor but is just as likely (if not more so), going to result in doubling your losses.