Triple Witching
On the same trading day, triple witching refers to the expiration of contracts for stock options, futures, and stock index options. This occurs on the third Friday of March, June, September, and December, four times per year. Convergence in the expiration dates of the three distinct categories of equity derivatives may engender a surge in trading activity and atypical price fluctuations in the underlying assets.
Understanding Triple Witching
Triple witching days engender trading activity and volatility due to the potential requirement to purchase or sell the underlying security when contracts are permitted to expire. Although specific derivative contracts may be initiated to purchase or sell the underlying security, traders who are solely interested in derivative exposure must terminate, roll out, or neutralize their open positions before the trading day’s closure on triple witching days.
Triple witching days, precisely the triple witching hour, which is the last hour of trading before the closing bell, may cause increased volatility and trading activity as traders roll out, conclude, or neutralize their expiring positions.
Futures on a single stock were last traded in the United States in 2020.
The practice of grouping them with stock options, index options, and index futures resulted in the expression “quadruple witching.” However, they could have attracted significant capital or trading interest compared to other forms of equity derivatives, particularly stock options.
Futures Offsetting Positions
A futures contract is an agreement to purchase or sell an underlying security at a predetermined price on a specified day. The mutually agreed-upon transaction must occur after the contract’s expiration.
To illustrate, the valuation of a single E-mini S&P 500 futures contract is fifty times that of the index itself.
The contract is valued at $200,000 if the S&P 500 is at $4,000 at expiration; the contract proprietor is responsible for payment of this amount if the contract is permitted to expire.
The contract proprietor cancels the agreement by selling it before expiration to avoid this obligation. Exposure to the S&P 500 index can be sustained by purchasing a new contract in the forward month after the closure of the expiring contract. The process described here is known as “contract rolling out.” On triple-witching days, most futures and options activity is devoted to rolling out, offsetting, or closing positions.
Contract owners can cancel their agreements before expiration by entering into an offsetting trade at the current price. This lets them settle potential losses or gains from purchase and sale prices.
Traders may also prolong the contract through a process known as “rolling the contracts forward,” which involves offsetting the existing transaction and concurrently reserving a new option or futures contract for future settlement.
Expired Choices
Options in the money (ITM) place contract holders of expiring options in a comparable predicament. For instance, the underlying shares may be called away from the vendor of a covered call option if the share price closes above the strike price of the expiring option.
The vendor of the options has the choice of either closing the position before expiration and maintaining ownership of the shares or allowing the option to expire and having the shares called away.
Call options are profitable and expire in the money when the underlying security’s price exceeds the strike price specified in the contract. When the underlying stock or index’s strike price is lower than the put option’s effective price. The expiration of in-the-money options triggers automated transactions between the contract purchasers and vendors in both scenarios. Consequently, triple-witching dates result in a more significant proportion of these transactions being finalized.
Triple witchcraft and arbitrage occur.
While most trading activity in futures and options contracts during triple witching days is associated with position squares, the increased activity can also cause price inefficiencies, which attract short-term arbitrageurs.
Triple witching days frequently conclude with heavy volume as traders attempt to profit from minor price imbalances by executing large round-trip transactions that can be completed in seconds.
Notwithstanding the general surge in trading volume, triple witching days do not invariably result in significant volatility.
An Illustration of Triple Witching in Practice
The year 2019 began with its first triple witching day on Friday, March 15, 2019. Before the third Friday of the month, there was a notable surge in trading volume and market activity. As per Reuters’s report, the U.S. market exchanges’ trading volume on March 15, 2019, was “10.8 billion shares, which is an increase from the average of 7.5 billion shares over the previous 20 trading days.”
The S&P 500 increased 2.9% in the week preceding Friday’s triple witching, whereas the Nasdaq and Dow Jones Industrial Average (DJIA) rose 3.8% and 1.6%, respectively. However, most gains occurred before triple witching on Friday, as the S&P only gained 0.50 percent, and the Dow gained 0.54 percent that day.
Questions Asked Frequently
Why is witching performed in triples?
Mythologically speaking, the witching hour is a period during the day when evil forces may be at work. This has been colloquially applied to the hour of contract expiration in derivatives trading, which is frequently Friday after trading.
Triple witching occurs when three distinct contract types—listed index options, single-stock options, and index futures—expire concurrently.
When is triple witching most prevalent?
Triple witching typically occurs at 4:00 p.m. EST on the third Friday of March, June, September, and December.
What Motivates Traders to Be Concerned With Triple Witching?
Due to the simultaneous expiration of multiple derivatives, traders frequently attempt to liquidate their entire open position before the expiration date. This may result in intraday volatility and an increase in trading volume. Prominent short-gamma positions expose traders to a heightened risk of price fluctuations before expiration. Arbitrageurs attempt to profit from such atypical price movements, but doing so is highly hazardous.
What price anomalies have been identified in the context of triple witching?
As participants attempt to close out or roll over their positions, triple witching typically coincides with above-average trading volume, which can increase volatility. Nonetheless, as gamma hedging occurs, an intriguing phenomenon is that the price of a security may tend artificially toward a strike price with substantial open interest.
Due to this trading activity, the price may “pin” the strike at expiration. Options dealers incur pin risk when they are unable to determine whether they should exercise extended options that have expired in the money or are very near the expiration date. Simultaneously, they are still determining the number of comparable short positions allocated to them.
Conclusion
- Triple witching occurs when contracts for stock options, futures, and stock index options expire on the same day.
- Triple witching occurs quarterly on the third Friday of March, June, September, and December.
- As traders roll out, terminate, or neutralize their expiring positions, the days may increase trading activity, especially in the final hour.
