U.S. stocks set for wild swings as trillions in options contracts set to expire Friday

“Quadruple witching,” as its known, happens when equity futures and option contracts tied to individual stocks and indexes —- as well as exchange-traded funds — all expire on the same day. Some option contracts expire in the morning, while others expire in the afternoon. This typically happens four times a year, roughly once per quarter.

Days like these sometimes coincide with volatility in markets as traders scramble to cut their losses or exercise “in the money” contracts to claim their winnings.

However, a top derivatives analyst at Goldman sees the potential for stocks to see even wilder swings in the sessions to come as a rash of contracts that have helped to suppress volatility in the equity market expire.

Options expiring on Friday could “remove the 4k pinner that has kept a lid on big moves,” said Scott Rubner, a managing director and top derivatives strategist at Goldman, in a note to clients obtained by MarketWatch. This could make the S&P 500 more vulnerable to a big swing in either direction.

“Either way. We are going to move next week.”

Since the start of the year, the S&P 500 has traded in a narrow channel of about 400 points bounded by 3,800 on the downside, and 4,200 on the upside, according to data from FactSet.

These levels correspond with some of the most popular strike prices for options tied to the S&P 500, according to data from Rubner’s note. A strike price is the level at which the holder of a contract has the opportunity — but not the obligation — to buy or sell a security, depending on the type of option one owns.

That’s not a coincidence. Over the past year, trading in option contracts on the verge of expiring, known as “zero-days to expiration” or “0DTE” options, has become increasingly popular.

One result of this trend is that they have helped keep stocks in a narrow range, while fueling more intraday swings within that range, a pattern that several traders have compared to a “game of ping pong.”

According to Goldman, 0DTEs represent more than 40% of average daily trading volume in contracts tied to the S&P 500.

Earlier this week, trading in 0DTEs helped keep the S&P 500 from breaking below the 3,800 level as markets reeled following the closure of three U.S. banks, according to Brent Kochuba, founder of SpotGamma, a provider of data and analytics about the option market.

Analysts says this is one reason that the Cboe Volatility Index VIX, -0.83%, otherwise known as the Vix or Wall Street volatility gauge, has remained so subdued compared with the ICE BofAML MOVE Index, a gauge of implied volatility for the Treasury market, Kochuba and others told MarketWatch.

The MOVE index awed traders earlier this week as volatility in normally placid Treasurys sent it surging to its highest level since the 2008 financial crisis. Meanwhile, the Vix VIX barely managed to break above 30, a level it last visited as recently as October.

But some believe this could change starting Friday.

To be sure, Friday isn’t the only session where large slugs of option contracts are set to expire over the next week. On Wednesday, a slug of contracts tied to the Vix will expire on the same day the Federal Reserve is set to announce its latest interest rate-hike decision.

“50% of all Vix open interest expires on Wednesday. That’s pretty significant,” Kochuba said during an interview with MarketWatch.

The end result is that this could help the Vix “catch up” to the MOVE, something that could result in a sharp selloff in stocks, according to Alon Rosin and Sam Skinner, two equity derivatives experts at Oppenheimer.

“The bottom line is this: more volatility is likely coming to the equity market,” Skinner said during a call with MarketWatch. “And the Vix is underpricing it.”

Amy Wu Silverman, an equity derivatives strategist at RBC Capital Markets, expressed a similar view. In emailed comments shared with MarketWatch, she said she expects “volatility levels to remain elevated” heading into next week’s Fed meeting.

Futures traders are pricing in a high likelihood that the Fed will hike its policy rate by 25 basis points. However, traders still see a roughly 20% chance that the Fed could opt to leave interest rates on hold, according to the CME’s FedWatch tool.

Source: finance.yahoo.com