Hot damn… Are you ready for Friday? It’s going to be a messy chop fest full of panic and disillusion. Tomorrow, you’ll wake up and hear the term “Quad Witching” quite a bit. What the heck is that? Well, four times – every year – the markets experience what is known as “Quadruple Witching Day.”
What is Quad Witching?
These expiration/speculation/hedging events happen on the third Friday of March, July, September, and December. These are typically days where we see a lot of volatility and unpredictability in the market. Every day, we talk about trading in the markets, and the most common trading tool we discuss is equity options contracts.
These are contracts that give people the right but not the obligation to purchase (Calls) a stock on or before a predetermined date or sell a stock (Puts) on or before that date (also known as the expiration date). Options contracts typically expire on Fridays (a few exceptions with ETFs). And whenever you hear someone look out into the future and say they are trading a contract for a specific month, they typically highlight the contracts of the “Third Friday” of that month.
Now, the Third Friday of these four months noted above is important. Not only do stock options expire tomorrow for a vast number of equities, but so too do three other asset classes. These are stock index futures, stock index options, and single stock futures.
All four classes expire all at the same time. So, there is a lot of money sloshing around. Many investors need to cover the margin on trades. There are shares exchanging hands at a breakneck pace. And investors are starting to look out to the next round of trades.
Why Third Friday Matters
I’ve highlighted events over 2021 to show you how unstable the market has become. At the year’s onset, we had a robust post-election rally, particularly in small-cap stocks.
However, the S&P 500 continued to climb – largely thanks to many capital flows into the Top 10 stocks on the index. Apple, Amazon, Meta (Facebook), and Alphabet (Google) saw large amounts of money move into those positions. But under the surface, the rest of the S&P 500 faced significant pressure dating back to February.
Not a lot of people know this. But the top 10 stocks on the S&P 500 have roughly the same combined market capitalization as the bottom 432 on the index combined.
So, those ten stocks might chug higher – pushing the index up – while the rest of the index experiences sharp selling. This is important to consider when evaluating broader market momentum (which remains negative, by the way, on Thursday).
Now, look at this chart. This is the SPY – which tracks the S&P 500 – dating back to the start of the year. You’ll see some nice moves higher over each month before a bit of deflation right in the center of the month. Those downturns coincide with options expiration – the Third Friday of the month.
The markets shrugged off these slight pullbacks in March and July and then pushed higher into the next month. But look at September. The entire market starts to break down during the September Quad Witching event.
Since then, we’ve struggled for a good read on any patterns in the market, and unpredictability and volatility have become the norm. In October, options expiration brought choppy movements, and in November, the Third Friday was right when that market momentum started a vastly negative trend.
Today, the Nasdaq plunged again – dropping almost 3% on the day before Quad Witching. I remind you that cash remains your friend right now. When market momentum is negative, my trading accounts go to at least 85% cash. I don’t stray from this position.
I will never be the man without a chair when the music stops. And I don’t want you to ever experience that feeling either. Let’s talk more about risk management tomorrow.