In function of the quarantine I started to dig a little deeper into the "Max Pain" principle and how market makers who write the options have to hedge the risk.
What I understood so far: Options are written by the market makers which in turn have to cover their naked option writing with the underlying value. They do this by remaining dynamic hedging to remain neutral. This causes the underlying value to be bought and sold.
This is the part where I get a little confused: If the underlying value rises then the value of a long call option will increase which causes the market makers to hedge more.
Is this done by buying more of the underlying value and therefore creating a diminish returns effect?
I also do not really understand why This rebalancing provides a force driving the stock to toward max pain.
If anybody could help me or point me into the right direction I would be really appreciative!
thanks in advance!