$5.5 Trillion Triple Witching in U.S. Financial Markets: Understanding its Impact and Implications

Disclaimer: The views and opinions expressed herein are the author's individual opinions and views and do not reflect Vanguard Investments views. These views are expressed to share insights and opinions and DO NOT constitute any financial advice. Please consult your financial advisors for any investment advice.Today, Friday, June 21, 2024, marks a significant event in the financial calendar. It is not only the quarterly rebalance of various indices but also a "Triple Witching" options expiration day. This convergence is expected to amplify market activity, potentially leading to heightened volatility and trading volumes. Triple-witching will involve the expiration of approximately $5.5 trillion in options linked to indexes, stocks, and exchange-traded funds, according to an estimate from options platform SpotGamma.

In the realm of U.S. financial markets, certain dates are marked with heightened activity and volatility, capturing the attention of traders and investors alike. One such phenomenon is known as "Triple Witching," a term that conjures images of market chaos and strategic maneuvering. Despite its dramatic name, Triple Witching refers to a predictable and routine occurrence that plays a significant role in market dynamics.

What is Triple Witching?

Triple Witching occurs on the third Friday of March, June, September, and December. On these days, three types of derivative contracts simultaneously expire: stock options, stock index futures, and stock index options. The convergence of these expirations can lead to increased trading volume and volatility as market participants adjust or close out their positions.

1. Stock Options: These are contracts that give the holder the right, but not the obligation, to buy or sell a specific stock at a predetermined price before the option expires.
2. Stock Index Futures: These are contracts to buy or sell a financial index at a future date, reflecting the performance of a specified market index.
3. Stock Index Options: Similar to stock options, these give the holder the right to trade an index at a set price before expiration.

Concurrent Rebalancing

On the same day as Triple Witching, the S&P will rebalance certain indices, including the S&P 500 (large cap), S&P 400 (mid cap), and S&P 600 (small cap). Additionally, various FTSE and Nasdaq indices will undergo rebalancing. This adds another layer of complexity and activity to the market as adjustments are made to align with the new index compositions.

The Mechanics

The simultaneous expiration of these derivatives can create significant trading activity as traders seek to hedge positions, unwind contracts, or roll over expiring contracts into new ones. Here’s how each player might behave:

• Institutional Investors: These entities, such as mutual funds and hedge funds, often hold large positions in derivatives. They may execute substantial trades to manage their portfolios, contributing to spikes in volume and volatility.
• Market Makers: Firms that provide liquidity by buying and selling securities may need to adjust their holdings to maintain balanced books, leading to rapid trading.
• Speculators: Traders looking to profit from the volatility might engage in short-term trades, further amplifying market movements.

The Impact

The effects of Triple Witching on the market can be multifaceted:

1. Increased Volatility: The need to close out or roll over large positions can cause significant price swings, especially in the final hour of trading, known as the "witching hour."
2. Higher Trading Volumes: The expiration of these contracts often results in a surge of trading activity, as evidenced by noticeable spikes in volume on Triple Witching days.
3. Market Movements: While the increased activity can lead to temporary distortions in stock prices, these effects are generally short-lived and tend to normalize quickly after the expiration.

Strategic Considerations for Investors

For the average investor, Triple Witching might seem like an arcane aspect of market mechanics. However, understanding its implications can offer valuable insights:

• Awareness of Volatility: Being cognizant of potential volatility spikes can help investors avoid unnecessary risks or take advantage of market movements.
• Long-Term Perspective: While short-term traders may seek to capitalize on the fluctuations, long-term investors might prefer to stay the course, recognizing that Triple Witching's impact is typically transient.
• Risk Management: For those with derivative positions, it's crucial to plan ahead for expirations and manage risks appropriately, considering the potential for sudden market shifts.

Trading Schedule and Mechanics

1. Equity Options: These have monthly expirations, trade throughout the day on expiration Fridays, and settle based on the closing price of the underlying stock.
2. Certain Index Options: These include the S&P 100 but not the S&P 500. They also expire monthly, trade all day on expiration Fridays, and settle based on the closing price of the underlying index.
3. S&P 500 Index Options: These expire on quarterly Triple Witching Fridays, stop trading on the preceding Thursday, and settle based on the opening price of all stocks in the S&P 500.
4. S&P 500 Index Futures: These expire on quarterly Triple Witching Fridays and derive their value from the opening price of all stocks in the S&P 500.

Investment Strategies

Traders may employ various strategies to hedge their positions:

• Index Options/Futures Hedge: For a bearish outlook on an index or sector, traders might go long on various components of that index. Conversely, for a bullish outlook, they might short various components of the index or sector.
• Equity Options/Futures Hedge: For a bearish position (owning puts), traders may go long on the stock. For a bullish position (owning calls), they might short the stock.

When these options expire, derivative trading desks cannot maintain their hedge positions. Since their core business is not optimizing stock prices, they tend to liquidate or cover their shorts regardless of the impact on equity prices. Institutions typically understand this and usually refrain from active trading on Triple Witching Fridays.

How the Closing Cross Works

Throughout the trading day, index managers enter market-on-close orders into the closing cross system for execution at 4 PM. The system tallies buy and sell orders, matches them, and identifies any imbalances. Fifteen minutes before the close, the system notifies traders of any imbalances, allowing them to provide liquidity to offset these imbalances. At 4 PM, if imbalances remain, the system seeks liquidity in the quote screen, systematically executing orders until the imbalance is resolved. This process ensures all participants receive a fair price, with the closing cross reflecting a block trade at 4 PM and setting the closing price for the index valuation.

Conclusion

By understanding the mechanics and implications of Triple Witching, investors can better navigate these periodic bouts of market activity, balancing the potential for short-term opportunities with long-term investment strategies.

Although volume remains high on expiration days, the associated volatility and importance have diminished over the years as traders unwind positions ahead of expiration. Consequently, expiration-related volatility may span the entire week leading up to the expirations. The separation of futures and options expirations over several days has also reduced Triple Witching volatility.

The volume and volatility tied to expirations are typically temporary phenomena with minimal long-term impact on stock trends, prices, and valuations. This activity is largely quantitative and arbitrage-related, not driven by fundamental buy or sell decisions. It falls outside the standard institutional universe and is thus not influenced by investor relations processes.

In most cases, these are volume events, so significant price movements are not usually expected.

Disclaimer: The views and opinions expressed herein are the author's individual opinions and views and do not reflect Vanguard Investments views. These views are expressed to share insights and opinions and DO NOT constitute any financial advice. Please consult your financial advisors for any investment advice.