Triple Witching in Futures Markets

Dec 17, 2021 02:36 PM ET
Triple Witching in Futures Markets

The term "triple witching" refers to the day in the financial markets when three different types of contracts, namely index options, stock options, and index futures, expire simultaneously. This happens on the third Friday of each quarter.

When large institutional investors roll over futures contracts to free up cash, it can generate significant changes in the volatility of the market. Doing so increases the trading volume significantly.

Witching hours

A witching hour occurs on the third Friday of the month when options and futures expire. The number of expired contracts determines how long each period is. The witching hour is the moniker given to the final hour of trade since all contracts expire at the same time.

Effects of triple witching

Triple witching has not always resulted in an "up" day for the markets, and neither has it always resulted in a "down" day. It does not represent the beginning of a new trend. It doesn't have a substantial impact on the market; rather, it provides a temporary boost in trading volume and liquidity.

While triple-witching in combination with index rebalancing events can cause substantial market movements, it is crucial to remember that market volumes tend to be greater not only on index rebalancing days but also during and following wider macroeconomic news events.

Expiration dates are a feature of futures and options contracts, which is a major difference between them and stocks. Futures traders are investors who have put substantial amounts of capital in line in the hope that market prices will move in their favor in the future.

During triple witching, they have to decide whether to roll their contracts over and keep a position in a non-expired contract or cancel their positions. In essence, they have to either purchase or sell the contracts, depending on their initial position. 

When many contracts expire all at once, it triggers a spike in trading activity in the market. The stock market isn't affected by triple witching, although it does see an increase in volume. Volatility does not arise as a result of the expiry of options and futures contracts but rather by the actions of traders based on the short-term price variations of their underlying assets, which might be changed by the increased volume of trading.

Therefore, arbitrageurs are always on the lookout for opportunities to make quick profits. It is the objective of an arbitrageur to benefit from a security's price inefficiencies by simultaneously purchasing and selling it. There is a high risk involved in this approach.

While witching days occur on a fairly regular basis, they can cause short periods of volatility in the market. Because their usual role in market operations and the instability they cause is integrated into market expectations, they're normally not that big of a deal.

Triple witching and Black Monday of 1987

On the Friday before Black Monday of 1987, a series of triple witching occurrences had triggered a quick selloff of options and futures contracts, causing stock prices to plummet in pre-market trading. Because there were no systematic stop gaps to block the large sell orders, the financial markets were destabilized throughout the world throughout the day.

Regulators learned from the experience and implemented "circuit breakers" that would allow the exchanges to temporarily suspend trading in the case of a big sell-off, which they did.

How traders leverage triple witching

It is up to the individual day trader to decide how to manage triple witching based on their own trading style, strategy, and level of expertise. In the days preceding up to and on Triple Witching Friday, new traders may want to exercise greater caution.

Day traders who want to trade during this period should ensure that their current approach performs well in this environment or devise a new strategy just for this week. If you're a swing trader, you may want to keep an eye out for any statistical biases that may be present in the market in the period leading up to and after the event.

Although you can exercise an option at any time, futures contracts can only be exercised once, and you must fulfill them on expiration regardless of whether it will result in a profit or loss. 

You can manage triple witching contracts in three ways as they approach expiration:

  1. Determine the best way to close the deal, either by delivering the asset in person or by paying the same amount in cash.
  2. In order to extend the contract's term, you might choose to roll the position over. To compensate for the pricing disparities, you may have to pay a fee.
  3. Before a contract expires, you can either purchase or sell an equal quantity of the underlying asset to offset your position.

In summary

In conclusion, investors should be aware of the events taking place these days and recognize that there is a significant increase in trading volume in the markets. Short-term emotions should not lead investors to make hasty decisions based only on price fluctuations. 

The market always has a way of stabilizing after triple witching. Therefore, you should not be hasty in your decision-making. In addition, there are measures that you can employ to cushion your position in the period leading to triple witching.

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