Quadruple witching is the buzzword among equity traders this week.
But what is it and how will it affect stock markets?
What are the key dates to watch for options expiry?
Quadruple witching is the buzzword for equity markets this week as a slew of derivative contracts expire this week as it is September and a quarterly expiration. Futures contracts traditionally expired in March, June, September, and December. Initially, futures contracts developed as commodity futures which helped commercial operators to hedge the price of commodities such as pork bellies, cotton, orange juice and other agricultural commodities. This gradually expanded into financial futures contracts as speculators took to trading futures and futures exchanges launched new contracts to take advantage of growing demand among speculators. Financial futures contracts are now some of the biggest in the world and it is estimated futures contracts on the major equity indices far outweigh the underlying volume on the stock exchanges and drive the price rather than the stock market itself.
Futures contracts were set to expire on the third Wednesday of the month but with the introduction of options contracts on those futures, those were set to expire two Fridays before the third Wednesday in what was known as International Monetary Market (IMM) dates. Eventually, all the dates were brought together for stock derivatives to streamline things leading to one day with multiple expirations. The expiry is at the close of the stock market. What we have now is 4 expirations, single stock options, single stock futures, index futures and index options so hence quadruple. Triple witching was a precursor as single stock options were only introduced around the turn of the millennium.
Single stock futures are legally binding contracts to buy or sell an underlying stock on a specific date, called the expiry date. An index future is slightly different as you do not take delivery of the underlying basket of shares in the index but instead settle the difference between your purchase price and expiry price, called cash-settled.
That is the big question and minds far greater than mine have been working out the answer to that question using powerful computers and algorithms to try and take advantage. What is generally accepted is that volume and as a result, volatility increases quite sharply on quadruple witching day. There are many reasons but a lot has to do with market makers trying to hedge positions in advance and flatten their trading book. Gamma is a word that has become quite trendy of late with a gamma squeeze making its way into trader speak. Gamma is the change in an option market makers hedged position (called delta). If you buy a call option from a market maker they will likely buy the underlying to fully or partially hedge the position, depending on their book positions etc. So far so easy when it comes to one stock. You buy an AMC call option, the market maker is now short the call option so buys some AMC stock to hedge.
But when it comes to a stock index, the situation gets trickier. You buy a Tesla call option so now the market maker is short Tesla calls and so short Tesla stock essentially. He or she can buy Tesla stock to hedge but Tesla is a member of the S&P 500 Index so the S&P 500 futures and options traders in the same bank/broker may have positions that need hedging in which Tesla is but one of 500 stocks they need to buy or sell to hedge. If you buy the SPY or S&P 500 future a broker/market maker can hedge the position, run the position or hedge the top few stocks in the index such as Apple, Amazon, Facebook, Microsoft and Tesla. Those five stocks are 20% of the index.
A broker will therefore have hugely complex and potentially interlinked systems which will analyse in real-time any arbitrage positions and perfect hedging. There is no point in a broker going to buy Tesla to hedge his option position if another trading desk in the same broker needs to short Tesla as part of a basket related to the S&P 500 futures or options contracts. It gets tricky to explain and even trickier to trade and calculate and trust me I did this for 20 years! Adding to this are regulatory issues meaning one trading desk within a bank may have to be totally separate from another and so sometimes one desk may be short Tesla and another long without knowing it. But suffice to say working out what will happen then on quadruple witching day is the stuff of quant and black box trader speciality and even most of those struggle with the complexity.
Just look out for big spikes in volume and potentially big price spikes for no apparent reason. One general observation across the years is that the week after quadruple witching tends to be quieter than normal and prices have a slightly greater historical precedent for falling as demand for hedging has reduced or time is once again on the market makers side who has another three months before panicking and hedging!