If you believe that every trading session is the same, we are sad to inform you that you are incorrect. There are some dates in the calendar year that are more important than others. Every month, for example, there is an OPEX or Options Expiration day, which is usually the third Friday of the month.
Other dates include certain times of the month or quarter when funds and ETFs will rebalance their portfolios. But, probably most importantly, there is an infamous event that occurs four times per year, once in each quarter. It’s known as the quadruple witching day.
Definition of Quadruple Witching
Quadruple Witching, also known as quad witching, is a perfect storm of events. Each quarter, the quad witch day is held on the third Friday of the third month (March, June, September, and December). On quad witching days, four types of derivatives contracts expire: stock index futures, index options, stock options, and single stock futures. These trading days are often marked by substantially higher trading volume, though not always by increased market volatility.
Quadruple Witching’s Components
On quadruple witching days, four derivatives expire:
Single Stock Options
Single stock options grant the owner the right, but not the responsibility, to purchase an underlying stock at a predetermined price until the option expires. Every month, on the third Friday, options expire. Traders must execute or sell their options by that date or before. At expiration, profitable (in-the-money) options are automatically exercised.
Stock Index Options
Stock index options are similar to single stock options in that they reflect a whole stock index, such as the S&P 500, rather than a specific stock.
Stock futures contracts commit the owner to buy or sell a specific stock at a defined price on a future date. When a futures contract expires, the holder is required to acquire ownership of the shares, and the contract issuer is required to supply the shares. Every third month, stock futures contracts expire on the third Friday.
(It should be noted that single stock futures were launched in 2002.) Previously, quadruple witching days were known as triple witching days, and the words are now interchangeable.)
Stock Index Futures
Futures contracts that represent an entire stock index are known as stock index futures. Index futures contracts are usually settled in cash rather than shares.
How Does Quad Witching Work?
Because many large options contracts expire, are closed, rolled, or executed, extreme market volatility and generally unpredictable price behavior can result.
Volume and volatility have historically increased in the final hour of the New York session, which is sometimes referred to as “quad witching hour,” a reference to the folklore belief that there is a set time of night when witches appear and black magic is most effective.
Typically, the implied volatility of particular derivatives, as well as the VIX, will surge on or near the quad witching Friday.
Activity Relating to Option Expiration
Consider yourself to be a trader who is forced to make a decision on a quad witching day.
You own 1,000 shares of XYZ, a highly illiquid stock, and you’ve written 10 calls against the position, resulting in a buy-write (which is identical in P&L to a short put). The calls will expire on June 18th, the date of the next quad witching event.
When June 18th arrives, your calls will be rendered useless. You intended to roll them over to the next expiration date a few weeks ago, but you forgot. So it’s expiration day, and you’re at a loss for what to do.
You decide to roll the calls over to the next quarterly expiration, so you purchase them back and write 10 more at the following expiration.
It may appear straightforward, but your action is only a microcosm of all the potential trading that day.
You and many others are in the same boat, having to close, roll, exercise, or let your derivatives expire on that day. This is not merely an exceptionally high amount of volume for the derivatives markets; market makers also play a role.
Remember how we said XYZ was illiquid? Most likely, a market maker was on the opposing side of the deal.
And that market maker trades quantitatively using their options pricing model. As a result, they have no desire to take on your directional risk.
As a result, they must delta-hed the position by purchasing a proportionate amount of stock. If your calls have a delta of 0.10, they must buy 10 shares of stock each call to hedge the position.
This form of market maker hedging occurs on a daily basis and is usually unproblematic.
When that hedging becomes a much greater than usual share of the daily volume, we can witness some strange price activity, prompting traders to give this day the foreboding label of quadruple witching.
Consider a more complicated deal.
You have a long position in stocks and a short position in index futures. Perhaps your research indicates that this basket of index components will outperform the index as a whole until it expires.
By closing this position, you are simultaneously selling pressure on your basket of equities and buying pressure on the futures contract.
If many traders were similarly positioned, the futures contract may trade at a premium to “fair value,” which is simply the carry of the futures position: the value of the equities plus/minus dividends and the financing cost of holding the futures position.
What is the Level of Volatility on Quadruple Witching?
According to the media, any triple witching and options expiration day is a volatile day. Is this right?
Backtesting the S&P 500, the primary stock index, is the only way to find out.
The chart below shows the average of the last 50 observations on options expiry day (black line), quadruple witching (blue line – the flat “top” represents the observation), and any trading day (red line):
As you can see, we could claim that quadruple witching day is slightly more volatile than both expiry day and a random day.
How Quadruple Witching Affect Trading Volume
When traders, market makers, and funds roll over their holdings, the volume should rise, right?
Let’s backtest to see if the hypothesis is correct.
The average of the last 50 observations in the figure below indicates that the hypothesis is valid. The backtest is based on SPY daily volume.
Option expiry day (black line) and quadruple witching Friday (blue line) have significantly higher volume than any other day (red line).
Is Quadruple Witching Day Give Positive or Negative Return?
Let’s see if quadruple witching Friday is good or bad for stocks. We tested the following assumption:
- We buy SPY at the closing today, the Thursday before quadruple witching.
- We sell at Friday’s close and hence hold for 24 hours.
The equity curve is as follows:
There are 117 deals, with an average loss of 0.1% and a success rate of 51%. In comparison, the average overnight increase on any given day is approximately 0.05%.
Quadruple witching day is clearly bearish.
Quadruple Witching Week: Bullish or Bearish?
Let’s see if we can make money throughout quadruple witching week. We perform the following backtesting:
- On the opening day of the quadruple witching week, we go long at the open (Monday).
- We withdraw at the end of the options expiration week (Friday).
We arrive on Tuesday if Monday is a holiday. Similarly, if Friday is a holiday, we leave on Thursday.
The equity curve looks like this:
The 117 trades have a positive average of 0.45% per trade, with a 61% win rate.
We know that the quadruple witching day is a negative number, so let’s leave the day before the expiration date:
The average profit per transaction is roughly 0.6%, and the victory rate is 65%. (We consider the win rate to be one of the most important risk and performance indicators in trading.)
Quadruple Witching Hour: Bullish or Bearish?
At 1600 ET, the stock exchange closes official trading, and options and derivatives expire. Is the quadruple witching hour positive or negative?
Purchase ES futures one hour before the closure (3 PM) and sell at the close (4 PM). Since 2010, the average increase has been -0.08%:
The win rate is 31%, which is arguably the lowest we’ve ever seen in any S&P 500 strategy.
The quadruple witching hour indicates a bearish trend.
What is the Week After Quadruple Witching’s Return?
Our backtests of the options expiry week show that the week following options expiration has lower average returns than any other week. Of course, the four months per year with quadruple witching are included in this outcome.
Let us backtest the performance by entering at the close of the Friday in the four months of quadruple witching and exiting at the close of the following Friday, or five trading days later.
The equity curve looks like this:
The average gain per transaction is -0.05%, and the victory rate is 42%. As you can expect, this is much lower than any other week. It is worth noting, however, that both March and December exhibit quite positive growth. June and September are the worst months, with -0.57 and -0.75 returns, respectively. If we only invest for two months, the equity curve looks like this:
The winning percentage is only 29%. Prior to 1985, the negative impact was substantially smaller, but we must remember that the derivatives market only became a force in the mid-1980s.
If you’re an arbitrageur or derivatives trader, there’s no doubt that quadruple witching days and expiry Friday, in general, present tremendous trading possibilities.
However, if you’re an ordinary directional trader, you’re going to have to perform additional study to identify any specific patterns, as nothing stands out in the broad data we looked at in this essay.
There’s nothing wrong with keeping things simple and (a) sticking to your regular trading plan, or (b) simply sitting out the four days of quadruple witching each year.
We all have limited time for study, and it’s often best to focus on your main trading techniques rather than chasing potential edges outside of your core strength.