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Russell Rhoads
The Options Institute at CBOE

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In Like a Lion, Out Like a ... Witch?

Four times a year the stock market gives the business press something to talk about. No, it's not a huge rally or another unexpected market event, it's Triple Witching. On the third Friday of March, June, September and December, there is a convergence of expiration for three types of stock market related derivatives. This simultaneous expiration of equity options, index options and stock index futures contracts may result in a little extra market volatility, but probably not enough to justify the excitement generated by financial reporters.

The first of these three instruments are the options that trade on individual stocks and exchange-traded funds. Standard option contracts expire on the third Friday of every month. With expiration comes decision time for holders of these options. If there is value in an option contract or it is in-the-money at expiration, it will be exercised by the Options Clearing Corporation. Exercise will result in a buy or sell in the underlying security occurring over the weekend.

An option holder that wants to avoid the exercise process has the choice of selling the option before expiration. This choice results in an increase in option trading volume during the week of expiration, with a steady increase into expiration Friday. An increase in volume sometimes results in bigger swings in stocks and the market, hence the financial press focusing on Triple Witching.

The second event that contributes to Triple Witching is the expiration of options that trade on market indexes. These contracts expire on Friday, but many cease trading on Thursday with settlement based on the opening prices of the stocks that contribute to the index. This type of settlement is known as a.m. settlement.

As there is a risk in holding a contract overnight due to uncertainty surrounding the final settlement level for index options, many traders will exit their positions instead of waiting for the settlement price to be determined the next morning. Once again, more derivative volume may result in potentially increased volatility. Also, the settlement method for index options is done through a transfer of cash from short to long option holders.

This cash settlement is also the method used for the final instrument that creates the Triple Witching phenomena, stock index futures. The S&P 500® futures contract is the most liquid and the best known of this class of instrument trading in the US. The S&P 500 futures contracts expire on the Friday of Triple Witching, but actually stop trading the prior day. Like many index option contracts, these futures contracts follow an a.m. settlement format, with the opening print on each individual S&P 500 stock being used to determine the settlement value for the futures contract. Once again, due to a.m. settlement, many traders will exit positions to avoid the risk of a dramatic change in the level of stock between the close Thursday and the open Friday.

So Triple Witching involves an increase in volume for stock-related derivatives that, sometimes, results in an increase in market volatility. While reading old articles about Triple Witching, I was a bit amused at some of the comments in the financial press. My favorite one that was published before the open on a Triple Witching day is paraphrased here:

With today being Triple Witching Friday, the market may witness high volatility in the morning. If there is not too much volatility off the open, then expect there to be some near the close. It is also possible that the market may see volatility near the open and close as traders react to Triple Witching activity.

It is possible to say that about just about any trading day, Triple Witching or not. As far as longer term investors and traders go, Triple Witching is something we hear about when the TV is on in the morning and then we go about our day. These days may have some extra volume and maybe a little more volatility, but with the exception of being able to say it is Triple Witching day, for the majority of us, they are just like the other 250 or so trading days each year.

CBOE Volatility Index (VIX)