What Is Quadruple Witching?
The term quadruple witching refers to the date on which certain derivatives contracts expire simultaneously. This happens with four different types of contracts, including stock index futures, stock index options, stock options, and single stock futures. Quadruple witching dates occur four times a year on the third Friday of March, June, September, and December. Market activity on these days is typically highest during the last trading hour as traders try to move on these contracts.
- Quadruple witching refers to a date on which derivatives of stock index futures, stock index options, stock options, and single stock futures expire simultaneously.
- This event occurs once every quarter, on the third Friday of March, June, September, and December.
- Quadruple witching days witness heavy trading volume partly because of the offsetting of existing futures and options contracts that are profitable.
- Investors may take advantage of the increased volume and arbitrage opportunities that result from quadruple witching.
- Quadruple witching does not necessarily translate to increased volatility in the markets.
Understanding Quadruple Witching
As noted above, quadruple witching refers to a date when four different types of futures and options expire on the same day. These four contracts are stock index futures, stock index options, stock options, and single stock futures. When they expire, investors must make a move by adjusting their positions or closing out the contracts.
Quadruple witching is similar to triple witching, which is when three out of the four markets expire at the same time. Quadruple witching days replaced triple witching days when single stock futures started trading in November 2002. Because these contracts expire on the same triple witching schedule, the terms triple and quadruple witching are often used interchangeably even though there's a disparity in the number of expiring markets.
All witching dates derive their names from the volatility (or havoc) that results from these products expiring on the same day. When investors move on their positions, it can trigger significant volume and order flow. In folklore, supernatural beings are said to roam the earth during the witching hour of midnight such that being abroad at this time brings havoc and bad luck to those unfortunate enough to encounter these evil spirits.
Types of Contracts Involved in Quadruple Witching
Now that you know what quadruple witching is all about, let's take a look at the four classes of contracts that expire on these dates.
Options are derivatives, which means they base their value on underlying securities such as stocks. Options contracts give a buyer the opportunity, but not the responsibility, to complete a transaction of the underlying security on or before a specific date and for a preset price called a strike price.
There are two types of options:
- A call option can be purchased to speculate on a price increase in a particular stock. If the price is higher than the strike price at the option's expiration date, the investor can exercise or convert to shares of the stock and cash out for a profit.
- A put option allows an investor to profit from a decrease in a stock's price as long as the price is below the strike on expiration.
Options expire on the third Friday of every month. There is an upfront fee or premium to buy or sell an option.
An index option is just like a stock options contract, but instead of buying individual securities, index options give investors the right but not the obligation to transact the index, such as the S&P 500. Whether the index price or value is above or below the option's strike price on the expiration date determines the profit on the trade.
Index options don't offer any ownership of the individual stocks. Instead, the transaction is cash-settled. This gives the difference between the option's strike and the index value at expiry.
Single Stock Futures
Futures contracts are legal agreements to buy or sell an asset at a determined price at a specified future date. Futures contracts are standardized with fixed quantities and expiration dates. Futures trade on a futures exchange. The buyer of a futures contract is obligated to buy the underlying asset at expiry while the seller is obligated to sell at expiry.
Single stock futures are obligations to take delivery of shares of the underlying stock at the contract's expiration date. Each contract represents 100 shares of stock. However, holders of stock futures don't receive dividend payments, which are cash payments to shareholders from a company's earnings.
Index futures are similar to stock futures except investors buy or sell a financial or stock index with the contract settling on a future date. The existing position is offset when the contract expires, and a profit or loss is cash-settled into the investor's account.
Investors use index futures to bet on the direction of an index, buying if they believe the index will rise and selling if they believe the market will drop. Index futures can also be used to hedge a portfolio of stocks so that a portfolio manager does not have to sell the portfolio during market declines.
The futures contract earns a profit while the portfolio declines and takes a loss. The goal is to minimize short-term portfolio losses for long-term holdings.
Market Impact of Quadruple Witching
As noted above quadruple witching days witness heavy trading volume. One of the primary reasons for the increased activity is the options and futures contracts that are profitable settle automatically with offsetting trades.
Call options expire in-the-money and are profitable when the price of the underlying security is higher than the strike price in the contract. Put options are in-the-money when the stock or index is priced below the strike price. In both situations, the expiration of in-the-money options results in automatic transactions between the buyers and sellers of the contracts. As a result, quadruple witching dates lead to an increased amount of these transactions being completed.
Market indices such as the S&P 500 tend to decline in the week following quadruple witching. This may be due to the exhaustion of the near-term demand for stocks. Despite the overall increase in trading volume, quadruple witching days do not necessarily translate into heavy volatility.
Volatility measures the extent of price fluctuations in securities. Low volatility could be due to long-term institutional investors, such as pension funds managers who are largely unaffected since they don't change their long-term positions. The availability of a variety of hedging instruments with multiple expiration dates throughout the year has also diminished the impact of quadruple witching days to some degree.
While quadruple witching takes place four times a year, stock options contracts and index options expire more frequently—on the third Friday of every month.
Closing and Rolling Out Futures Contracts
Much of the action surrounding futures and options on quadruple witching days is focused on offsetting, closing, or rolling out positions. A futures contract contains an agreement between the buyer and seller in which the underlying security is to be delivered to the buyer at the contract price at expiration.
For example, one E-mini S&P 500 futures contract is worth 50 times the value of the S&P 500. So the value of an E-mini contract when the S&P 500 is 2,100 at expiration is $105,000. This amount is delivered to the contract owner if it is left open at expiration.
Contract owners don't have to take delivery on the expiration date. Instead, they can close their contracts by booking an offsetting trade at the prevailing price by cash settling the gain or loss from the purchase and sale prices. Traders can also roll their contracts forward, a process that extends the contract by offsetting the existing trade and simultaneously booking a new option or futures contract to be settled in the future.
The Chicago Mercantile Exchange delisted standard-sized S&P 500 index and options futures contracts in September 2021.
Over the course of a quadruple witching day, transactions involving large blocks of contracts can create price movements that may provide arbitrageurs the opportunity to profit on temporary price distortions. Arbitrage can rapidly escalate volume, particularly when high-volume round trips are repeated multiple times over the course of trading on quadruple witching days. However, just as activity can provide the potential for gains, it can also lead to losses very quickly.
Gives arbitrageurs the opportunity to profit on temporary price distortions
Increased trading activity and volume can lead to market gains
Market gains tend to be fairly modest
The potential for losses can be equally as evident as the potential for gains
Real-World Example of Quadruple Witching
There tends to be a lot of frenzy in the days leading up to a quadruple witching day. But it's unclear whether the actual witching leads to increased market gains. That's because it's impossible to separate any gains due to expiring options and futures from gains due to other factors such as earnings and economic events.
Friday, March 15, 2019, was the first quadruple witching day of 2019. As with any other witching day, there was hectic activity in the preceding week. According to a Reuters report, trading volume on U.S. market exchanges on that day was "10.8 billion shares, compared to the 7.5 billion average… over the last 20 trading days."
For the week leading into quadruple witching Friday, the S&P 500 was up 2.9% while the Nasdaq was up 3.8%, and the Dow Jones Industrial Average (DJIA) was up 1.6%. But many of the gains that happened actually seemed to occur before the quadruple witching Friday since the S&P was only up by 0.5% while the Dow was only up 0.54% Friday.
What Is Witching and Why Is It Quadruple?
In folklore, the witching hour is a supernatural time of day when evil things may be afoot. In derivatives trading, this term has been colloquially applied to the hour of contract expiration, often on a Friday at the close of trading. On quadruple witching, four different types of contracts expire simultaneously—listed index options, single-stock options, index futures, and stock futures.
When Does Quadruple Witching Occur?
Quadruple witching usually occurs on the third Friday of March, June, September, and December during the last hour of the trading day.
Why Do Traders Care About Quadruple Witching?
Because several derivatives expire at the same moment, traders often seek to close out all of their open positions in advance of expiration. This can lead to increased trading volume and intraday volatility. Traders with large short gamma positions are particularly exposed to price movements leading up to expiration. Arbitrageurs try to take advantage of such abnormal price action, but doing so can also be quite risky.
What Are Some Price Abnormalities Observed on Quadruple Witching?
Because traders try to close or roll over their positions, trading volume is usually above average on quadruple witching, which can lead to greater volatility. But one interesting phenomenon is that the price of a security may artificially tend toward a strike price with large open interest as gamma hedging takes place, a process called pinning the strike. Pinning a strike imposes pin risk for options traders, where they become uncertain whether or not they should exercise their long options that have expired at the money, or are very close to being at the money. This happens because they are also unsure of how many of their similar short positions they will be assigned on at the same time.