Like the ’60s icon Donovan once declared, “Must be the season of the witch.” In option trading, the season of the witch comes four times a year, and it is almost upon us. The term “triple witching” was originally used to describe the day that index options, equity options and index futures all commenced trading in their expiring contracts. Though some of the major index options now stop trading on the Thursday before expiration, the third Friday of the month ending each quarter is still a day of note for option traders.
The “witchiness” of this day stems from the fact that option volume and the volume of the underlying stocks tend to be higher on that day, which sometimes leads to unexpected, magnified price swings. This could mean more risk.
But this witch needn’t necessarily be feared, shunned or burned at the stake. While this anomaly makes many traders and investors a bit nervous, a solid understanding of the phenomenon can make you a better, more successful trader.
A lot of traders, especially professionals who have been in the game a long time, like to go into expiration “flat the strike.” That means they generally like to close out the at- and near-the-money options about to go off the board. If a trader is long near-the-money options, he’ll sell them to get to zero contracts. If a trader is short near-the-moneys, he’ll buy them. Getting rid of expiring long options avoids the higher risk of accelerated theta that comes with expiration. Closing out short options avoids pin risk, or the risk of not knowing whether or how many options will be assigned.
All this option trading can be accompanied by greater volume in the underlying stock as professional (i.e., delta neutral) traders also close out their hedges by buying or selling stock. Depending on which way the liquidity providers were positioned in the options (long or short, calls or puts), this spike in stock volume may cause upward or downward pressure.
Understanding triple witching and being prepared for its implications should be part of traders’ strategy going into the quarterly expiration. Simply appreciating the fact that the underlying security can have these moves and knowing why gives traders the opportunity to adjust their trading plan for that day to factor in a potential “surprise” move.
Passarelli started his trading career on the floor of the Chicago Board Options Exchange (CBOE) as an equity options market maker. He also traded agricultural options and futures on the floor of the Chicago Board of Trade (CBOT). In 2005, Passarelli joined CBOE Options Institute and began teaching both basic and advanced trading concepts. Be sure to visit Dan's Blog Trading Option Greeks and site Market Taker Mentoring