What is triple witching hour?
Triple witching is the third Friday of March, June, September and December. On this day, options, index futures and options on index futures expire concurrently. Massive trades in options and underlying stocks by hedge strategists and arbitrageurs can cause above average volume and added market volatility.
Derivative contracts based on stock indices do not generally involve the actual exchange of any underlying security. Instead, they are cash settled based on fair market value at a specified time. Many arbitrage strategies involve simultaneous, offsetting transactions in a basket of stocks representing an index and a derivatives contract on the index. When the derivatives contract reaches expiration, the usual practice is to buy or sell the basket of stocks at the exact price used for cash settling the derivatives contract.
In the early 1980's when organized futures and options exchanges began trading standardized contracts based on stock indices, that final value of those indices for cash-settlement purposes was usually the close of trading on the third Friday of the month.
Every month there is expiration on options and options on the futures. However, expiration of the futures only occurs once a quarter. This is where a large portion of the arbitrage activity takes place. So on the third
Friday of the last month of each quarter, orders to buy or sell huge quantities of stock at exactly the closing price used for cash settling the derivatives contracts deluge the stock exchanges. The industry began to call this combined expiration of options, futures and options on futures the triple witching hour.
Because these arbitrage strategies were market-neutral and simply took advantage of price discrepancies between the index and derivatives on the index, they didn't represent any real opinion on the market's direction. Unwinding only one side of the strategy with a market order and letting the other side cash-settle sometimes caused huge gyrations in the markets during the final hour of trading on the third Friday of that month.
Eventually, many expiring contracts switched from using Friday's closing price to using opening price or trading range for each of the component stocks to determine settlement values. This lessened pressure for immediate execution at any price. It also allowed for delayed openings due to order imbalances at exchanges with such procedures.
While the triple expiration of options, futures and options on futures can still impact how the market opens on that day, today we rarely observe the kinds of gyrations that routinely occurred in those early days.
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