What is the witching hour?

The final hour of trading on the third Friday of the month, when options and futures on stocks and stock indexes expire, is known as “the witching hour.” Heavy volume trading occurs at this time as traders close out options and futures contracts before expiration. In contracts with later expirations, positions are often reopened beyond that.

Understanding Witching Hours

The last trading hour before derivatives contracts expire is known as the “witching hour.” Traders often use terms like “triple witching,” which describes the expiry of stock options, index options, and futures on the same day. This event takes place on the third Friday of March, June, September, and December.

The phrase “quadruple witching” originated because single stock futures were traded in the United States between 2002 and 2020 and expired on the exact quarterly timetable. Double witching occurs on the third Friday of the eight months that aren’t triple witching. The contracts that expire on double witching are options on equities and stock indices.

Two activities occur during monthly witching hours: buying the underlying asset and rolling out or closing expiring contracts to prevent their expiration. Because of the potential imbalances that arise during the placement of these transactions, arbitrageurs also look for opportunities brought about by inefficiencies in pricing.

Motives for Offsetting Positions

Contracts not closed out may result in the purchase or sale of the underlying securities, which is the leading cause of the increased activity during witching hour days. For instance, open-ended futures contracts mandate that the seller provide the contract buyer with the agreed-upon amount of the underlying commodity or asset.

When an option is in-the-money (ITM), the underlying asset might be exercised and given to the contract owner. In either scenario, the contract must be closed out before it expires if the contract writer or owner cannot pay the entire cost of the security that must be given.

Conversely, rolling out, or rolling ahead, refers to closing a contract that is about to expire and replacing it with a new contract that will expire later. After completing the expiring position and settling any gain or loss, the trader establishes a new position in a different contract at the market’s going rate. This process produces volume in the contracts that are about to expire and the ones that traders are entering.

Possibilities to Arbitrage

Apart from the higher volume resulting from contracts being offset during witching hours, pricing inefficiencies and consequent arbitrage possibilities may also arise during the last hour of trading. Because of the large volume coming in quickly, opportunistic traders look for supply-and-demand mismatches.

For instance, contracts that signify substantial short holdings can fetch a higher price from traders who anticipate buying the contracts to liquidate positions before they expire. In these situations, traders could close contracts before the witching hour ends, selling them for a temporary premium. Alternatively, they might purchase the contract to ride the upswing and sell it when the purchasing frenzy wanes.

Conclusion

• The last trading hour before options or other derivatives contracts expire is known as the “witching hour.”
• Heavy volume trading is typical as traders try to roll or close out holdings.
• It’s called double or triple witching when many derivative contracts expire on the same day.