What is a 'Witching Hour'
The witching hour occurs on the last hour of trading on the third Friday of each month as options and futures on stocks and stock indices expire. This period is often characterized by heavy volume as traders close out options and futures contracts for the purpose of opening new positions in forward months.
BREAKING DOWN 'Witching Hour'
A triple witching hour refers to the expiration of stock options, index futures options, and index futures on the same day. These events occur on the third Friday of March, June, September and December. Because single stock futures also expire on the same triple witching schedule, the terms quadruple and triple witching are used interchangeably.
Double witching hours occur on the third Friday of the eight months that don’t have triple witching hours. Generally speaking, the expiring contracts are for options on stocks and stock indices.
The activity that takes place during monthly witching hours can be broken down into two categories: rolling out or closing expiring contracts avoids sales and purchases of underlying securities. Additionally, due to the imbalances that can occur as these trades are being placed, arbitrageurs also seek opportunities resulting from pricing inefficiencies.
Reasons to Offset Positions
The primary reason for escalated activity on witching hour days is contracts that are not closed out may result in the purchase or sale of the underlying security. For example, futures contracts that are not closed out require the seller to deliver the specified quantity of the underlying security or commodity to the buyer of the contract. Options that are in the money may result in the underlying shares being assigned for purchase to the owner of that contract. In both cases, if the leveraged contract owner is not in a position to pay the full value of the security to be delivered, the contract has to be closed out prior to expiration.
Contract sellers have a variety of reasons to close contracts during witching hours as well. For example, the seller of a stock option that is in the money at expiration may have the underlying shares called away. If there is a sizable gain, the seller may be liable for a big tax bill.
Opportunities for Arbitrage
In addition to the escalated volume related to the offsetting of contracts during witching hours, the last hour of trading can also result in price inefficiencies that can present arbitrage opportunities. Due to heavy volume coming in over a short time frame, opportunistic traders seek imbalances in supply and demand for contracts that temporarily distort prices.
For example, contracts representing large short positions may be bid higher momentarily if traders expect the contracts to be purchased to close positions prior to expiration. Under these circumstances, traders may sell contracts at temporarily high prices and then close them out prior to the end of the witching hour.