Quadruple Witching

What Is Quadruple Witching?

Quadruple witching refers to a date on which stock index futures, stock index options, stock options, and single stock futures expire simultaneously. While stock options contracts and index options expire on the third Friday of every month, all four asset classes expire simultaneously on the third Friday of March, June, September, and December.

Understanding Quadruple Witching

Quadruple witching is similar to the triple witching dates, when three out of the four markets expire at the same time, or double witching, in which two markets out of the four markets expire simultaneously.

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 witching" and "quadruple witching" are often used interchangeably (despite the disparity in the number of markets).

Quadruple, triple, and double witching all derive their names from the volatility — or havoc — inherent in all of these derivative products expiring on the same day. In folklore, supernatural beings are said to roam the earth during the witching hour of midnight; 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

Here are the four classes of contracts involved in quadruple witching.

Options Contracts

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.

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, and there is an upfront fee or premium to buy or sell an option.

Index Options

An index option is just like a stock options contract, but instead of buying individual securities, index options give investors the right — 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, giving 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

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. At expiry, the existing position is offset, 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 decline. 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.

Instead, 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

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.

Following the week of quadruple witching, the market indices such as the S&P 500 tend to decline, perhaps due to exhausting the near-term demand for stocks. Despite the overall increase in trading volume, quadruple witching days do not necessarily translate into heavy volatility.

Volatility is a measure of the extent of price fluctuations in securities. The 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. Also, the availability of a variety of hedging instruments with multiple expiration dates throughout the year has diminished the impact of quadruple witching days, somewhat.

Closing and Rolling Out Futures Contracts

Much of the action surrounding futures and options on quadruple witching days are focused on offsetting, closing, or rolling out positions. A futures contract contains an agreement between the buyer and the seller in which the underlying security is to be delivered to the buyer at the contract price at expiration.

For example, Standard & Poor’s 500 E-mini contracts, which are 20% of the size of the regular contract, are valued by multiplying the price of the index by 50. On a contract priced at 2,100, the value is $105,000, which is delivered to the contract owner if the contract is left open at expiration.

On the expiration date, contract owners do not take delivery and instead, can close their contracts by booking an offsetting trade at the prevailing price cash settling the gain or loss from the purchase and sale prices. Traders can also extend the contract by offsetting the existing trade and simultaneously booking a new option or futures contract to be settled in the future — a process called rolling the contracts forward.

Arbitrage Opportunities

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.

Real-World Example of Quadruple Witching

Friday, March 15, 2019, was the first quadruple witching day of 2019. The frenzy leading up to Friday during that week led to increased market activity. However, it's uncertain as to whether the witching leads to increased gains in the market since 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.

According to a Reuters report, trading volume on March 15, 2019, on U.S. market exchanges 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%. However, it appears many of the gains happened before 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, at market close (4:00 pm ET).

Why Do Traders Care About Quadruple Witching?

Because several derivatives expire at the same moment, traders will 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 will try to close or roll over their positions, trading volume is usually above average on quadruple witching, which can lead to greater volatility. However, 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 very close to being at the money. This is because, at the same time, they are unsure of how many of their similar short positions they will be assigned on.