Friday is the first day of spring. It is also the first "triple-witching" options expiration during what has already been a busy year for markets.
Investors are bracing for what could be a doozy of a trading session.
The notional value of contracts due to expire is slightly lower than the record amount that rolled off in December. Friday's expiration tally is about $6.4 trillion, compared with more than $7 trillion in December, according to figures from SpotGamma, a provider of data and analytics for the options market.
More notable than the volume of Friday's expiration is the heavy slant toward puts. A put option typically pays off when stocks are moving lower. They can be used to protect a portfolio against further short-term pain in the stock market, or to speculate on a decline. Nearly 60% of S&P 500 Index options due to expire on Friday are puts, according to SpotGamma.
With the Cboe Volatility Index VIX, better known as the VIX or Wall Street's "fear gauge," trading above 24 on Thursday, investors clearly were on edge about the continuing conflict in Iran.
The options expirations come at a busy time for markets. The Iran conflict has spurred volatility in markets, with oil's (CL00) (BRN00) surge weighing on both stocks and bonds. Meanwhile, the quarterly rebalancing of the S&P 500 also will be finalized at Friday's close. Typically, index-rebalancing days see a rush of trading volume around the closing bell, as funds update their weightings, add new additions and sell shares of companies that have been removed from the index.
"Normally, what I would say would happen here is we would clear out the puts and we would get a market rally off of that," Brent Kochuba, founder and CEO of SpotGamma said. "But with the Iran situation, it's looking really tricky. Because people need to maintain volatility exposure."
What is 'triple witching'?
Every quarter, there is one day when options contracts tied to individual equities - that is, stocks and ETFs - expire at the same time as contracts tied to equity indexes, such as the S&P 500, as well as index futures contracts.
These "triple-witching" days have a reputation for heightened volatility and a generally higher level of activity in the U.S. equity market.
A Dow Jones Market Data analysis of historical data showed that between January 2020 and this past week, triple-witching days saw roughly one-third more trading volume than non-triple-witching days. The volume data included in the below chart represents the average total daily volume from the New York Stock Exchange, NYSE Arca, NYSE American and the Nasdaq combined.
Higher volatility is also a hallmark of triple witching, according to Mike Thompson, co-CIO at Little Harbor Advisors. Thompson, along with his brother, Matt Thompson, manages portfolios with a focus on volatility and risk-management. An analysis by Dow Jones Market Data found that the S&P 500 has tallied an average decline of 0.5% on triple-witching days since January 2020.
The real risk, according to Matt Thompson, is what happens in the days after a triple witching. "It's a time when positioning gets flushed out and reset. You'll get more of a natural market movement for a few days," he said.
Since the Iran conflict began, investors haven't seen a big upward spike in the VIX that might signal a buyable bottom for stocks, Mike Thompson said. That could mean investors are in for more pain ahead, as major selloffs typically reach their crescendo as the volatility gauge peaks.
"Things haven't gone off the rails yet. The market is bending, but it isn't breaking," Mike Thompson said. Both Thompson brothers said they have been keeping a close eye on the VIX futures curve, which has shown front-month contracts trading at a premium to contracts later out. Oftentimes, an inverted futures curve signals a bottom is in, or at least nearby. But with oil prices continuing to climb, and stocks trading lower as a result, seemingly anything is possible.
Lately, investors have been selling profitable put options and profitable VIX calls. This dynamic may have helped protect U.S. stocks from some of the blowback from the Iran conflict, according to the Thompson brothers.
But since contracts tied to the VIX expired on Wednesday morning, investors have been reupping their hedges, said Noel Smith, chief investment officer at Convex Asset Management. This may have contributed to some of the volatility seen on Wednesday as Federal Reserve Chair Jerome Powell delivered his latest post-meeting press briefing. Smith said investors were blindsided by Powell's claim that he plans to remain at the Fed until a federal investigation into repairs of the central bank's headquarters has been completely put to rest.
Should Powell stick around after his term ends on May 15, that could put a damper on the market, Smith said. Meanwhile, the hope that President Donald Trump could still find a swift off-ramp from the Iran conflict has helped keep stocks from selling off harder.
The fact that implied volatility is higher across asset classes is another factor that investors should consider. The wide gap between the level of the VIX, and the relatively tame daily swings in the S&P 500 means that now is a favorable environment for investors to generate income by selling options, Smith said.
But Jordan Rizzuto, chief investment officer at GammaRoad Capital Partners, said investors expecting a quick turnaround for markets might be putting too much stock in historical patterns. By now, practically every professional investor has probably seen a table showing stock-market selloffs driven by previous geopolitical shocks have tended to be short-lived, he said.
"We think that is dangerous thinking, because it treats all geopolitical events as a homogenous group. But each geopolitical event has its own idiosyncrasies," Rizzuto said.
U.S. stocks finished lower on Thursday, with the S&P 500 SPX seeing its lowest finish since November. The Dow Jones Industrial Average DJIA and Nasdaq Composite COMP were also lower.
