Shattering the Quadruple Witching Volatility Myth

Quadruple witching Fridays do not cause volatility, but rather, exacerbate the underlying move

Dec 21, 2015 at 9:31 AM
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    Well, that was certainly an interesting week. As is often the case, we didn't actually move much net-net, down less than 1%. But that, of course, belied the actual volatility.

    We had a major event -- the historic rate hike. We then had "relief" over said rate hike, then consternation over said rate hike, culminating in yet another "can't go home long this weekend, sell everything" Friday.

    For a year that's not seen much in the way of a net move, we sure have a lot of these terrible Friday tapes. And this one was quadruple witching!

    As is often the case on witches, the "pundit sphere" started talking up quadruple witch volatility well before the opening bell. To which I tweeted:

    Let me explain, since 140 characters often tends to cause more confusion than clarity. Quadruple witching is that glorious day four times a year where pretty much every product everywhere has options expiring. Some are on the open -- I'm looking at you, S&P 500 Index (SPX) -- but most are on the close. When options expire, it can cause a self-fulfilling move in the markets, as owners and shorts need to adjust their positions to the fact that all non-cash-settled options are either turning into shares of stock or into worthless wallpaper. Thus, players need to adjust in order to not have too much exposure.

    It sounds like it will cause an avalanche of volatility, and that's clearly a common perception. But it's not the reality. There's no statistical evidence quadruple witches are excessively volatile. That's mainly because option longs don't always "win."

    It's important to remember that options are a zero-sum game. For every option short getting squeezed on a volatile day, there's an option long getting a big payday. What witches (and, really, any expiration) tend to do is pile on the volatility move already in progress. It doesn't actually cause the volatility, and that's where the big misconception lies.

    Consider a very quiet and non-volatile day that coincides with an expiration. Option longs are now the ones under pressure, as any premiums on their longs are about to evaporate. They often try to offset that erosion by either selling the options outright (perhaps rolling into a later cycle) or flipping stock around a strike price they own.

    Remember expiration pinning? Seems like a topic from another era, but that's the dynamic. Option shorts can more or less sit back and collect much of their remaining premium. In these sorts of days, quadruple witch tends to dampen volatility.

    Last Friday was, of course, the opposite. Option shorts were scrambling, and that tends to feed on itself -- as the worse the market gets, the more pain and the more necessity to pile on the selling in order to defend bad positions. Further, losses on option shorts are open-ended, whereas losses on option longs are limited to whatever you paid. Thus, the moves on volatile expirations are relatively large.

    Quadruple witch very likely added onto what was already an ugly day. In 2015, ugly Fridays have become so common that I'd guess that played a factor, as well.

    None of this is at all to say quadruple witch is irrelevant. Rather, I'm saying it's overstated as a vol driver. Don't go load up on volatility ahead of the next one, as it's just as likely to be a dud as it is to be a monster vol day. I'd even suggest it's more likely to be a dud, as it's likely too many will play for a vol explosion next go around.

    Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.


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