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Q: What does the term "triple witching hour" mean?
A:Triple witching is the third Friday of March, June, September and December, when 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, but rather are cash-settled based on some 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 an expiration on options and options on the futures. But expiration of the futures, where a large proportion of the arbitrage activity takes place, only occurs once a quarter. So on the third Friday of the last month of each quarter, stock exchanges would be deluged with orders to buy or sell huge quantities of stock at exactly the closing price used for cash-settling the derivatives contracts. This combined expiration of options, futures and options on futures came to be known as the Triple Witching Hour.
Because these arbitrage strategies were market-neutral, simply taking advantage of price discrepancies between the index and derivatives on the index, they didn't represent any real opinion on the market's direction. But 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 of these expiring contracts switched from using Friday's closing price to using the opening price or trading range for each of the component stocks in determining their settlement values. This lessened the pressure for immediate execution at any price, and allowed the possibility of delayed openings for order imbalances at exchanges that have such procedures in place. So while the triple expiration of options, futures and options on futures can still have an impact on how the market opens on that day, the kinds of gyrations that routinely occurred in those early days is rarely observed today.
Q: Why do options expire on the third Friday of the month?
A: Technically speaking, standardized options expire on the Saturday following the third Friday of the month. The reason that equity and index options expire on this day is due to the fact that this day offers the least number of scheduling conflicts, i.e. holidays.
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