Trading of stock index futures, stock index options, stock options, and single stock futures increases in four special sessions a year. This fast cluster of trades makes the prices of such derivatives more unstable and volatile. Here's why that happens and how it impacts on stock markets.
Shares and bonds might be what first spring to mind when we think about the stock market; but stock index futures, stock index options, stock options and single stock futures are some listed securities that also pique investors’ interest — so much that markets have special “witching hours” to trade them on the third Friday of March, June, September and December. "Witching" is where the contracts simultaneously expire, causing trading to soar in the last hour. Because of unusual price movements, sessions are dubbed the “quadruple witching hour”, or “Freaky Friday” in stock market lingo.
Knowing how stock index futures, stock index options, stock options, and single stock futures work will help you understand "witching".
Which securities are traded during the “quadruple witching hour”?
An option is a derivative contract whose value is pegged to another underlying asset. It gives investors the right, but not the obligation, to trade a security at a pre-set price upon its expiry date. The investor pays a premium to hold the option.
An option's underlying asset can be a share or a stock market index. For share options, imagine that a company’s shares are trading at 20 euros each. You pay a premium of 5 euros for the right to buy the shares in a certain time frame at 22 euros each. If the share's price is higher than the sum of the premium and the option price (i.e. 5 + 22 euros) when the contract expires, you can receive a return if you buy the share.
Index options are similar but consider the price shift of an entire stock index (e.g. the IBEX 35 in Spain and the Dow Jones in the US).
A futures contract is also a derivative whose price is pegged to an underlying asset. It can be not only on shares and stock indices (which is what we explain here), but also on loans, deposits, commodities and other assets.
In a futures contract, a buyer and a seller agree to trade a financial product in the "future". They set the price and settlement date in advance. Unlike an option, a futures contract will be traded according to its agreed terms and conditions.
If you’re convinced a company’s share price will increase and you buy futures on its shares, you’re making sure you get those shares at their current price, even though you may actually buy them at a later date while the contract is still in force.
When the contract expires, the buyer and the seller must hold their end of the bargain, for which they will have provided collateral.
Though most stock markets operate in similar ways, share futures trading does not exist in the US. When only stock options, stock index futures and stock index options contracts expire on the same day, the last hour of quarter-end trading is called the “triple witching hour”. We must also consider that expiry changes according to time zone.
What’s behind quadruple witching?
Stock index futures, stock index options, stock options and single stock futures have expiry dates (usually at the end of the month or the quarter), which match up on the third Friday of March, June, September and December. These expiry dates are investors’ last chance to exercise their options, confirm their futures or extend contracts to the next expiry date. In the last hour of trading, markets are flooded with orders, raising volatility.
However, because digitalization has enabled investors to trade online, quadruple witching has started to lose substance. Instead of waiting until the eleventh hour to trade, investors can now automate trades or execute them at any time during the week. This reins in volatility.
Learning what happens will help you understand how stock markets and investment products work. If you’re thinking of investing, get advice from an expert. Futures and options can cause sharp market fluctuations that investors must be prepared for. Check out these 10 practical tips for investing in the stock market (in Spanish) on Santander Consumer España’s blog, Tu Futuro Próximo (“Your near future”).