Quadruple witching

Witching in financial markets is an image borrowed from the "witching hour" — a supernatural time of night when witches, ghosts and demons are believed to be at their most powerful. The witching analogy was first applied to financial markets in the 1980s, when stock index futures and stock index options started trading in the United States.

In the 1980s, analysts noticed that on days when stock index futures and stock index options expired, markets would experience wild price swings in the final hour of trading, as large investors closed their option positions prior to expiration. The swings were so wild compared to other trading days that the market almost seemed to be spooked.

Later in the 1980s, U.S. regulators aligned the monthly expiration of stock options to the same Friday used for the quarterly expiration of stock index futures and stock index options. This caused even larger quarterly unwinding activity from investors and traders across three derivatives, forming a "triple witching" event.

In 2002, stock futures were launched. U.S. regulators aligned the quarterly expiration of stock futures to the same cycle, creating a "quadruple witching" event. However, stock futures stopped trading in the U.S. in 2020, since their volume was relatively small compared to the other three derivatives. As a result, the U.S. market has now returned to "triple witching," although by convention many investors still refer to it as "quadruple witching."

On witching days, large investors, traders and market-makers need to exit or adjust their positions. Now, let’s discuss some typical reasons why they need to do this.

To avoid physical delivery or cash settlement

A hedge fund may sell index futures to hedge its equity portfolio. Its goal is to offset market risk, not actually sell shares in the index. The hedge fund "unwinds" by buying back futures contracts. If it doesn't, the fund may face a more complicated and costly cash settlement process.

To realize profits or losses on a speculative trade

A trader buys a call option to speculate on short-term price appreciation. If the stock price rises, the option gains value. To lock in that value, the trader must sell or unwind the option before it expires.

To remove directional bias

A market-maker wants to provide liquidity, not make directional bets on the market. As an at-the-money option approaches expiration, its hedge ratio or delta may change violently with small moves in the stock price. A market-maker may have to buy and sell stock frantically to keep their position market-neutral. It's often cheaper and safer for the market-maker to close the position, rather than try to hedge it.

To exit complex, multi-leg strategies

Multi-leg strategies like calendar spreads or short straddles may involve significant risk of loss. To reduce this risk, a trader often unwinds the position by buying back all the legs. This multi-leg selling pressure adds significantly to trading volume and volatility on witching day.

To comply with trading rules

Many institutional investors operate under strict trading rules that prohibit holding derivatives to expiration or taking physical delivery of the underlying stock.

These reasons show there's nothing spooky or supernatural about witching day, despite its name. The volatility near the end of witching day is mechanically caused by large investors unwinding their option positions at the same time.

Quadruple witching, although a U.S. event, tends to spill over to other global markets, including Canada. As the U.S.-listed stocks of Canadian companies are swept up in the options selling pressure of the U.S. market, traders quickly close any gaps that might open up between these companies' share prices on U.S. and Canadian exchanges. Even investors who only hold Canadian stocks should be aware that quadruple witching in the U.S. typically means higher volatility for Canadian stocks.

Here are some ways investors in stocks and options can prepare for witching days.

Use limit orders or avoid trading until Monday 

Placing market orders near the close of quadruple witching day exposes investors to the risk of unfavorable execution prices. Liquidity can become fragmented and order books may thin out as investors rush to complete trades before the close. Even large-cap, highly liquid stocks can experience abrupt price gaps and slippage, causing investors to buy at unexpectedly high prices or sell at unexpectedly low prices.

To manage execution risk on witching day, investors can either use limit orders or simply avoid trading until Monday. Investors should be mindful about the risks of trading stocks that make up a large part of their portfolio on witching day, especially transactions that involve swapping one large holding for another. Unless you absolutely have to trade stocks on the Friday afternoon of witching day, consider waiting until Monday afternoon, when the witching spell has usually been lifted. 

Manage the risk of option assignment 

For investors holding short option positions, the risk of assignment — being required to buy or sell the underlying security — becomes much higher as expiration approaches. The increased trading activity and volatility on these days can lead to rapid changes in option prices.

To manage assignment risk, investors should closely monitor their short option positions as witching day approaches. Even options that are moderately out-of-the-money may be assigned if prices move sharply during periods of much higher volatility. Investors may need extra buying power —cash and margin — to cover assignment risk. Additionally, investors should remain vigilant about early assignment risk, particularly for options on stocks that pay dividends near expiration.

Proactive risk management strategies include closing out or rolling over short option positions before the afternoon session of witching day, especially if the options are nearing or are already in-the-money. Additionally, buying offsetting options or underlying shares can potentially hedge against assignment risk and limit potential losses.

Witching checklist 

• Avoid trading on witching day afternoons unless absolutely necessary. If you must trade at this time, consider using limit orders rather than market orders.
• Monitor short options for early assignment and review ex-dividend calendars.
• Confirm buying power is adequate to cover assignment risk.
• Close or roll short options before witching day to avoid assignment risk.

• Quadruple witching means that four U.S. equity derivatives — stock index options, stock index futures, stock options and stock futures — expire on the third Friday of March, June, September and December. The event is called quadruple witching by convention, even though stock futures are no longer traded in U.S. markets.
• Stock and option pricing on witching days is more volatile than on other days, due to large investors unwinding option positions at the same time — whether to avoid physical delivery or cash settlement, realize profits or losses on speculative trades, remove directional bias, exit multi-leg strategies or comply with trading rules.
• Witching day is a U.S. event but also affects the Canadian market. Even investors who only hold Canadian stocks should be aware that quadruple witching in the U.S. typically means higher volatility for Canadian stocks.
• How to prepare for witching days? Investors can avoid trading on witching day afternoons or use limit orders if they must trade at this time, monitor short options for early assignment and review ex-dividend calendars, confirm buying power is adequate to cover assignment risk and close or roll short option positions before witching day to avoid assignment risk.