What is Witching Hour
Witching hour is the last hour of trading on the third Friday of each month as options and futures on stocks and stock indexes expire. This period is often characterized by heavy volume as traders close out options and futures contracts before expiry. Positions are then often re-opened in contracts that expire at a later date.
Breaking Down Witching Hour
Witching hour is a general term. More often traders will use terms such as "triple witching."
A triple witching hour refers to the expiration of stock options, index futures options, and index futures on the same day. This event occurs 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 hour occurs on the third Friday of the eight months that aren't triple witching. On double witching, the expiring contracts are typically options on stocks and stock indexes.
The activity that takes place during monthly witching hours can be broken down into two categories: rolling out or closing expiring contracts to avoid the sale and purchases of the underlying asset. 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 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 asset being exercised and assigned to the contract owner. In both cases, if the contract owner or contract writer 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.
Rolling out or rolling forward is when when a position in the expiring contract is moved into a contract expiring at a later date. The trader closes the expiring position, settling the gain or loss, and then opens a new position at the current market rate in a different contract. This process creates volume in the expiring contract and the contracts the traders are moving into.
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 example, contracts representing large short positions may be bid higher 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. Or, they buy the contract to ride the up wave, then sell once the buying frenzy slows down.