What Is Quad Witching In The Stock Market?

Quad witching in the stock market is an interesting thing, which happens very rarely.

It is a day that brings together the expiration of four types of derivatives. The cumulative impact of the trading frenzy on that day has the potential to disrupt the entire market.

We dive deep into how quad witching impacts stock price movements and what it means for traders.

What is Quad Witching in the Stock Market?

Quadruple witching is when stock index futures, stock index options, and stock options face simultaneous expiration. It happens only four times a year – on the third Friday of March, June, September, and December.

If you are wondering why this event is termed “quad” when we mentioned only three, there also used to be a fourth one.

Single stock futures, which were introduced in 2002, were discontinued after 2020.

They no longer trade in US markets, though they exist in other parts of the world.

Hence, effectively, quadruple witching is triple witching now.

The significance of multiple expiries on the same date is that it causes a huge surge in trading volume.

Due to the rollover, closure, and settlement activity in the derivatives markets, quadruple witching Fridays are one of the highest volume days in the year.

Traditionally, analysts believe that this could have significant implications for stock prices.

Most assume that the day has a bearish influence.

This article will explore quadruple witching and how it impacts the markets.

Types of Contract Expiry on Quadruple Witching Day

As explained above, three types of contracts expire on this day (with a fourth one now being discontinued).

Below, we explain each of them.

Stock Options

An options contract offers the right (but not the obligation) to its buyer to trade a certain stock with two conditions: 

• At a specified price (strike price)
• Prior to a pre-decided date (expiration date)

They are a derivative instrument because their value comes from the underlying stocks.

The key point to note here is the expiry date. For stock options, it happens on the third Friday of every month.

These contracts can be of two kinds: calls and puts.

The former lets their buyer purchase the underlying share, whereas the latter allows them to sell it under the above conditions.

Calls become profitable when the share’s value becomes higher than the strike price and puts work in reverse.

Options can be purchased at a value known as their premium (which is significantly lower than buying the actual shares).

Importantly, they continue to have a certain price and are traded just like securities until the expiration date is reached.

At that point, there are two scenarios possible. The contract could either be “in the money” or “out of the money.”

If it’s the former, the buyer can take physical delivery and square it off for a profit.

In the latter event, the option expires worthless.

Index Options

These are specific types of options whose underlying asset is a stock index instead of an actual share.

Their value derives from the movement of this index relative to the strike price.

One key difference with other options is that these are always cash settled.

They cannot be closed through physical delivery since their underlying asset is notional.

Additionally, they cannot be expired at any time prior to the date of the expiry.

Index Futures

A futures contract offers the right to buy or sell a security at a specific price on a given date.

The key difference as compared to options is that they also entail an obligation to make the trade on expiry.

Index futures use stock indexes as their underlying assets.

Like their option counterparts, these are cash settled on the expiration date.

Single Stock Futures

These are futures with a single underlying stock.

They are not available to trade in the US after 2020.

When Does Quadruple Witching Occur?

There are four quadruple witching days a year, including the third Friday of March, June, September, and December.

Options contracts lapse on the third Friday of each month.

Index derivatives expire on the same day, but their frequency is only once a quarter.

The confluence of these two events creates the four quadruple witching dates we mentioned above.

Is Quad Witching Bullish or Bearish?

Data seems to indicate that while the quad witching days themselves are bearish, the week preceding the event is bullish.

Moreover, there is general agreement that the days following the event are bearish, specifically in the June and September months.

The last point is likely because of a lack of demand for stocks.

The quadruple witching hour, or the last 60 minutes before markets close on this day, is also slightly bearish.

However, despite what the results show, witching events do not significantly impact price volatility.

Most of the extra volume generated is due to trading derivative expiry.

Ideally, it should not have any direct bearing on stock price volatility or movement.

How Does Quad Witching Affect the Markets?

On the quad witching day, all in-the-money options risk facing automatic delivery.

Let us first explain what that means, taking the example of a call option.

As explained earlier, calls are profitable when the underlying asset’s price is higher than the strike price.

This is because the trader gets the right to buy the stock at a lower value than the market and sell it for a profit.

However, after the exercise date, this facility will no longer be available to them.

Sometimes, the investor might expect the stock price to go even higher.

Therefore it may be beneficial for them to keep the option going.

The possibility that the investor would lose their position is called “pin risk.”

At this point, the holder of the option has two choices.

They could either settle it or else roll over to the next period.

Closing it out would require selling the securities, which increases the trading volume.

This significantly impacts liquidity and other important parameters when done at a market-wide level.

For example, the inventories of market makers get reduced due to the excessive volume of trades.

This could be why the week after is usually slow – since the demand for many securities falls significantly.

However, as mentioned earlier, these actions do not necessarily translate to huge volatility.

Rolling Over / Offsetting of Futures Contracts

Apart from taking physical delivery, investors in derivatives contracts can also choose to roll over or offset their positions.

Off-setting is simply creating a reverse trade to cancel out the holding.

This results in a cash settlement.

The option holder gets the difference between their purchase price and the final sale value of the contract.

On the other hand, rolling over involves selling the option and buying it again for the next cycle.

In effect, this is the same as continuing the contract for another period.

Rolling over does not impact stock volume directly.

Arbitrage

The exchange of several large tranches of contracts on a single day sometimes creates pricing distortions.

Arbitrageurs try to cash in on such opportunities, which helps close the gaps and bring the bid-ask prices back in line.

This activity also adds to increased trading volume on witching days.

Trading Quad Witching Example

Let’s think of a trader facing the abovementioned situation on quad witching day.

Suppose they hold 500 securities of XYZ firm and have also written five calls against the position.

The call options will expire on March 17, the next witching day.

If they are in the money on that day, it might make sense to roll them over to the next date – June 16.

To do this, the trader sells their call options and then buys new ones with the same strike price but an expiration date three months ahead.

This won’t significantly impact trade volumes.

However, consider the situation when they are unsure of where the security might be headed.

In such a case, closing the option and booking profit, or taking delivery and then selling it at market price, might make sense.

In the second scenario, an additional volume gets added to the market, which would not have been there otherwise.

Even in the case of rollovers and closures, some market makers might have been hedging the options with actual stocks.

Those shares would need to be bought or sold to maintain the required holdings, which also contributes to the additional volume.

Is Quad Witching a Profitable Day?

As mentioned earlier, the average historical returns on the quad-witching day are bearish.

This is particularly true for June and September but not so much for the remaining two quarters.

However, past performance does not guarantee future trends. Hence, the above data cannot be relied on entirely for making trading strategies.

Moreover, no analysis shows that the higher volume created due to closing off certain contracts necessarily creates price volatility.

Therefore, it is very much possible that quad witching day is just like any other on the market.

Whether it is profitable or not depends on the positions you take based on fundamental and technical analysis.

Final Thoughts

Despite the rather evocative name given to witching days, they are not very unlike any other day of trading on the stock market.

The confluence of expiration dates for four major types of derivative contracts certainly generates a lot of additional volumes.

The traditional thought process assumes that it might potentially create significant price disruptions.

However, data does not support this idea.

At best, the day is slightly more bearish than others, and the week prior is bullish.

In most cases, the analysis also shows that the days afterward are bearish, especially in June and September.

Partly the reason could be that while volumes rise up several times, price volatility does not get impacted by these events.

Lastly, traders should not base their strategies on the analysis of past data or unsupported hypotheses.

It is best to stick to fundamental and technical analysis when creating positions to trade.