19 September 2018

What Is Quadruple Witching?

In financial markets, an expiration date is the last day that a derivative, such as options or futures, is valid. On or before this day traders and investors must decide what to do with their expiring position.

Before an option expires, those that own the option can choose to exercise (put into effect the right specified in a contract) the option, close the position to realize their profit or loss, or let the contract expire worthless.
Futures traders holding the expiring contract must close it on or before expiration, often called the "final trading day," to realize their profit or loss. Alternatively, they can hold the contract and ask their broker to buy/sell the underlying asset that the contract represents. Retail traders don't typically do this, but some businesses do, such as an oil producer using futures contracts to sell their oil. Futures traders can also "roll" (traders roll over futures contracts to switch from the front month contract that is close to expiration to another contract in a further-out month...) their position.
Triple witching is the name of a market event that happens 4 times per year. It occurs when the contracts for stock index futures, stock index options and stock options all expire on the same day. There are regular options expirations every month, but on the third Friday of March, June, September and December the additional contracts noted above expire as well.
In 2002 triple witching days became quadruple witches as the expiration of single stock futures was added to the party. As a result, there are actually four types of expiring contracts, but the name "quadruple witching" apparently has too many syllables so it never caught on.
On quadruple witching days (especially during the last hour of trading), activity can escalate and lead to a spike in volatility as traders close, roll out or offset their expiring positions.

Understanding Quadruple Witching

Quadruple witching days tend to generate elevated trading activity and volatility because expiring contracts may necessitate the purchase or sale of the underlying security. While some derivative contracts are opened for the purpose of buying or selling the underlying security, traders seeking actual derivative exposure must close, roll over or offset their open positions prior to the close of trading on quadruple witching days.
Expiring Futures Positions
A futures contract, is an agreement to buy or sell an underlying security at a predetermined price on a specified day. It requires that the agreed-upon transaction take place after the expiration of the contract. For example, one electronic mini futures contract on the Emini S&P 500 is valued at 50 times the value of the index. If the index is priced at $2,900 at expiration, the underlying value of the contract is $145,000, which is the amount the contract owner is obligated to pay if the contract is allowed to expire.
To avoid this obligation, the contract owner closes the contract by selling it prior to expiration. After closing the expiring contract, exposure to the S&P 500 index can be maintained by purchasing a new contract in the current “front month.” This is referred to as “rolling” a contract.

Expiring Options

Options that are in the money (profitable) present a similar situation for holders of expiring futures contracts. For example, the seller of a covered call option can have the underlying shares called away if the share price closes above the strike price of the expiring option. In this situation, the option seller has the option to close the position prior to expiration to continue holding the shares, or allow the option to expire and have the shares called away.

Quadruple Witching and Arbitrage

While much of the trading in closing, opening and offsetting futures and options contracts during triple witching days is related to the squaring of positions, the surge of activity can also drive price inefficiencies, which draws short-term arbitrageurs (investors who attempt to profit from price inefficiencies in the market by making simultaneous trades that offset each other to capture risk-free profits.) These opportunities are often the catalysts for heavy volume going into the close on quadruple witching days, as traders attempt to profit on small price imbalances with large round-trip trades that may be completed in seconds.

Bottom Line

Quadruple expiration is a time of explosive volume and volatility. Given the crosswinds created by the competing (and sometimes conflicting) needs of market participants it’s also a good time for day traders like myself (and you if you’re into it) to tread lightly… if at all.
#quadruplewitching #optionsexpiration #oex

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