(Bloomberg) -- Just as Wall Street traders come to grips with the Federal Reserve’s interest-rate cut, Friday’s US options expiration threatens to whipsaw the market some more.
The quarterly “triple-witching” will see some $5.1 trillion worth of options tied to individual stocks, indexes and exchange-traded funds fall off the board, according to an estimate from derivatives analytical firm Asym 500. While the risk is sometimes overblown by Wall Street players, the options event has a reputation for causing sudden price moves as contracts disappear and traders roll over their existing positions or start new ones.
This quarter’s expiration comes at a crucial juncture for market positioning following the Fed’s decision on Wednesday to cut interest rates for the first time since the depth of the pandemic. While the S&P 500 Index is less than 1% from its record, the Cboe Volatility Index, or VIX — which gauges expected swings in the S&P 500 — is holding above levels from before the market slumped in late July and early August, suggesting investors are still somewhat cautious.
“Triple-witching will likely inject more volatility into the market — we just don’t know which direction,” said Matt Thompson, co-portfolio manager at Little Harbor Advisors. “Whatever the market’s opinion is about the Fed cutting rates will be exacerbated by a large options expiration on Friday.”
Once again, the options expiry coincides with the rebalancing of benchmark indexes including the S&P 500, suggesting a bevy of investors will actively trade around those positions, with single-day volumes typically ranking among the highest of the year. Before the market opens on Monday, Dell Technologies Inc., Erie Indemnity Co. and Palantir Technologies Inc. will replace Etsy Inc., Bio-Rad Laboratories Inc. and American Airlines Group Inc. in the S&P 500.
The bulk of open interest for both puts and calls is concentrated around the S&P 500’s 5,500 level, according to Tanvir Sandhu, chief global derivatives strategist at Bloomberg Intelligence. The index has largely stayed within 200 points of the threshold in recent weeks, fueling speculation that the tight trading range was a function of options activity that made it a battle line for investors and market makers.
Weak seasonality has also played a role in the past, with triple witching in September typically being followed by an equity swoon the ensuing week. Since 1990, the S&P 500 has slumped 1.1% on average the week after September options expiration, according to the Stock Trader’s Almanac. There have only been four exceptions where stocks saw across the board gains in that stretch: 1998, 2001, 2010 and 2016.
That said, the size of options positions expiring is 4-to-1 in favor of call versus put positions, which helped stocks deliver their best five-day stretch of the year last week, according to Brent Kochuba, founder of options platform SpotGamma. Given that Nvidia Corp. is trading with a high amount of calls relative to the rest of the market, that should serve as a “catalyst for further equity upside,” he said.
“The recent stock rally reduced large put positions, which relieved downside hedging pressure into the FOMC meeting and VIX expiration,” Kochuba said. “This reduced hedging pressure allows for more potential volatility over the next week.”
That’s why traders are monitoring Wall Street dealers on the other side of options transactions, who buy and sell stocks to maintain a market-neutral stance. These dealers are “short gamma,” if the S&P 500 slides below 5,600, according to Kochuba, and in order to remain neutral will have to start selling stock below that level.
Now, as many contracts expire, the crucial question is whether investors will rebuild their holdings of protective puts on economic growth concerns — or will they chase this month’s market rebound, buying call contracts with the S&P 500 hovering near a record.
“If the Fed’s rate cut is interpreted as too little too late, protective puts may be bought, which could then drag the market lower if dealers are forced to hedge,” said Thompson of Little Harbor Advisors. “But if cuts are received well...that would support stocks.”
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