How Wicked is the Quadruple Witching?

by Adam Warner | September 17, 2012 1:01 am

September options expire Friday, but it’s not just any expiration day, it’s a quadruple witching day. Quadruple witching days, which occur on the third Friday of March, June, September and December, see the simultaneous expiration of stock options, index options, index futures and single stock futures.

The expiration of single stock futures is why triple witching became quadruple witching, and this just makes the day seem all the more terrifying. But the truth is neither is cause for concern.

Among other things, not all options and futures expire simultaneously. S&P 500 futures expire on the opening. They do not actually trade on Friday; they simply cash settle based on the opening price of each component stock (not the opening of the SPX itself). SPX options cash settle on the open as well.

Regular stock options and ETF options, such as SPDR S&P 500 ETF (SPY) options, trade all day Friday, and require actual delivery of stock if/when exercised/assigned.

The markets separated the expiration this way a number of years ago, and it seems to have worked in that quadruple witching day is not particularly volatile … most of the time.

When it is volatile, though, quadruple witching (or any expiration really) has greater potential to increase the magnitude of a move. We’ll call this the “gamma effect,” and it can strike out of the blue.

Consider a near-money equity call on expiration. It literally goes binary as the underlying stock either closes above strike, in which case the call is an exercise and becomes stock, or it closes below strike, in which case the calls expire worthless.

Suppose you’re short the calls to start the day and they’re modestly out of the money (OTM), but then the market rallies and the stock busts through the strike. You watch at first, but it keeps going. Now those calls you are short and about to rip up will suddenly get you short stock. So you cover, i.e., buy stock.

On the margins, you’ve added to the buying pressure, and perhaps caused the next guy to cover even higher, and so on. Then, before you know it, it’s gone through the next higher strike and the next group of option shorts takes action. Lather, rinse, repeat.

We now have a stock in motion that’s literally going up simply because it’s going up.

And the amazing thing is, this is the lucky group, because stock option shorts can actually cover their positions.

What if instead you’re short SPX options on expiration Friday and there’s news in the pre-market. Your calls stopped trading the night before and will simply cash out on the open. What was worthless the night before may now have real value against you. And what’s worse is you won’t actually have a short going once the market opens, merely a cash settlement against you.

It’s a tricky position to hedge, to say the least. If you think a stock through strike can cause some chasing, imagine the gang that’s short index calls.

Sound far-fetched and scary? Well, we saw it happen in August 2007, when the Fed chose the expiration pre-open to announce a surprise rate cut and caused a huge pre-open ramp that literally fed upon itself and eviscerated any index call shorts. Either the Fed doesn’t understand options expiration or it intentionally chose that moment to achieve maximum impact. Neither is a comforting thought.

But I digress …

Back to the Witches

The above was a very outlier event. The bottom line is that most expiration days are rather quiet and non-volatile, even the witching days. But if you do see a body in motion, be extremely careful, as the move can intensify.

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