By Mark Hulbert
Be on your guard against market manipulation on Friday, Sept. 15, which is a triple-witching day.
"Triple witching" refers to those four days each year -- the third Fridays of March, June, September, and December -- in which stock options, stock index futures, and stock index options all expire. It's widely known that such days often experience unusually heavy volume and volatility. But what has been less well-known is that prices on these days display a puzzling and costly pattern, according to a just-completed academic study. Retail options traders are the victims.
The amounts involved are substantial: The researchers were able to document a wealth transfer of nearly $4 billion a year from the victims to those who profited, and the actual total is most likely significantly greater. And because this apparent manipulation has been going on for at least two decades, the total amounts to over $100 billion. The study that documented the phenomenon, entitled "The Equity Derivative Payoff Bias," was conducted by Guido Baltussen of Erasmus University Rotterdam and Robeco Quantitative Investments, Julian Terstegge of the Copenhagen Business School, and Paul Whelan of the Chinese University of Hong Kong. The study began circulating this week on the Social Science Research Network.
In an interview with Barron's, Baltussen emphasized that he and his fellow researchers don't have positive proof that manipulation is taking place. But he said that they examined all the other possible explanations they could think of, and in each case found that they couldn't account for the patterns they found in the data. In contrast, market manipulation can explain all the observed patterns and is therefore believed by the researchers to be the most likely cause.
Baltussen said that they also found evidence of this likely manipulation when S&P 500 index options expire on the third Fridays of every month, not just on triple-witching days. However, the magnitude of the manipulation was larger on triple-witching days.
To understand what they found, a certain amount of technical detail is necessary. Specifically, the manipulation can be traced to the difference between two prices:
-- The opening price of the S&P 500 index itself on expiration day, which is
computed from the opening prices of the S&P 500 stocks at the 9:30 a.m.
Eastern time market open or, when those stocks don't immediately start
trading at 9:30, from closing prices from the preceding business day.
Delayed openings can occur for any of a number of reasons, such as when
there are large order imbalances.
-- The Special Opening Quotation (SOQ), which is the price used to calculate
the value of S&P 500 options at expiration. The SOQ is based on the
opening prices of each of the 500 stocks, and is only available once all
of them have established an opening price.
In theory, any differences between these two prices should average to zero over time. That is, on some expiration days the SOQ will be higher than the index open, and on others will be lower -- with no systematic bias over time. This turns out to be the case for all other days other than the third Fridays of the month, on average. However, it is not the case when it matters in practice, according to the researchers: The SOQ is higher than the index open far more often than not on the third Friday of each month, on average.
As a consequence, the settlement prices of S&P 500 call options are inflated and those of S&P 500 put options deflated.
The source of the pattern the researchers discovered is that traders appear to be exerting price pressure on S&P 500 stocks and pushing prices up in the overnight period from the close on the Thursday before options expiration to Friday's open. The researchers did not find evidence of similar price pressure on other days.
Baltussen says that it's relatively easy for traders to exert price pressure and push prices up in the overnight period because the market is relatively thin during that time. It's far harder to exert price pressure during the settlement of options at the 4 p.m. close of NYSE trading, given the market's much greater liquidity during the day session, and he and his fellow researchers found no evidence of possible manipulation in the case of options that expire then.
The major implication of this study for options traders: Avoid trading S&P 500 index options at or near their expiration. Many claim that the vast majority of option traders lose money, so the odds are already stacked against them. Manipulation at the expiration of S&P 500 options skews those odds even more.
The implication for market regulators is to change the way in which S&P 500 index options are settled. That would go a long way to ensuring that the markets are a level playing field.
Mark Hulbert is a regular contributor to Barron's. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com .
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September 14, 2023 12:21 ET (16:21 GMT)
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