The stock market is repeating a pattern of midmonth stumbles some analysts tie to options expiration. That dynamic could be amplified this week ahead of “quadruple witching,” the simultaneous expiration Friday of individual stock options, stock-index options, stock-index futures and single-stock futures.
Video: ETF Edge, September 13, 2021 (CNBC)
Options are financial instruments that give the holder the right but not the obligation to buy, in the case of a call option, or sell, in the case of a put option, the underlying asset at a set price by a certain time.
“Almost like clockwork, over the past six months the S&P 500 has fallen in the week leading into OpEx, so the risk is we see this flow repeat and come into play this week, which could mean weakness into Friday’s expiry — although perhaps it’s all too obvious now,” said Chris Weston, head of research at Pepperstone, in a Monday note. OpEx is trader slang for options expiration.
One popular explanation of the dynamic requires briefly translating some options lingo: Delta measures how much an options price is expected to change for ever $1 move in the price of the underlying asset. Gamma measures the speed of the change in an options delta.
The Friday expiration “should get some focus because the talk is market makers are long gamma, and this has had the effect of reducing volatility,” Weston wrote. Effectively, market makers who have sold options are taking positions in the underlying stocks or other instruments to hedge their market exposure.
“When this gamma rolls off the market, it typically means the index is free to move as it should, as market makers have less position risk to hedge,” Weston said.
Bloomberg previously noted bouts of market weakness ahead of the expiration of monthly stock options, which occurs on the third Friday of the contract month. The report observed that some analysts had tied bouts of weakness across equity markets in the days ahead of the monthly options expirations in February, April, June, July and August.
Heading into Friday’s quadruple witching — a convergence that occurs once every quarter and is typically associated with the potential for increased volatility and high trading volume — stocks were stumbling again. The S&P 500 fell 0.6% on Tuesday, leaving the large-cap benchmark down nearly 2% in the month to date. The S&P 500 has fallen in six of the last seven sessions, while the Dow Jones Industrial Average has declined in nine of the past 11 sessions.
Quadruple witching can make for choppy trading because “so many things are coming off at once, and firms unwinding positions versus each other and versus their stocks,” said J.J. Kinahan, chief market strategist at TD Ameritrade, in a phone interview.
That activity, combined with a lack of fresh trading catalysts, could continue to make for choppy price action in coming sessions, he said.
While there was some immediate reaction to a softer-than-expected inflation report Tuesday, the data didn’t significantly change market expectations. A meeting of Federal Reserve policy makers also appears unlikely to alter the status quo, and while a smattering of companies are offering up results, the market is effectively in an earnings lull before third-quarter reporting season gets under way next month, he said.
Kinahan, however, was less convinced that monthly options expirations has been a significant market driver in recent months. While the quarterly quadruple witching event is notable, the popularity of weekly options may have dulled the impact of monthly expirations somewhat, he said.
The Cboe Volatility Index a measure of expected volatility in the S&P 500 over the coming 30 days, has struggled to break above its long-term average near 20. But the gauge can likely stay in a range between 16 and 20 for some time, Kinahan said.
“Back-and-forth choppiness won’t end fully until we have a clearer picture on what the Fed is doing in terms of timing” when it comes to scaling back its stimulus efforts, he said.