Taking A Breather

Friday’s quadruple witching expiration could not come soon enough for many traders and the equity markets overall. Many of the violent moves that have characterized recent trading sessions were exacerbated by futures and options positions that expired this week.

One clue about expiration relief came from the CBOE Volatility Index (VIX) on Wednesday. On a day when the S&P 500 Index (SPX) fell by over 5%, VIX rose by less than 1%. VIX was flirting with record-high readings all week, but on Wednesday its rally seemed to ignore the broader market’s decline. The reason for this is that VIX futures and options expired on Wednesday’s open. With fewer outstanding near-term contracts came some relative calm in the volatility readings. And despite today’s gyrations in SPX, VIX is down about 3% as I write this.

With futures and index options expiring Friday morning, and equity and ETF options expiring at Friday’s close, I expect the whole financial system to breathe a similar sigh of relief. If for no other reason, a liquidity starved market will welcome the margin and haircut relief resulting from the removal of millions of outstanding options and futures contracts. Even though we are accustomed to monthly and weekly expirations, there is still a concentration of open interest and activity around quarterly expiries.

The volatility of recent sessions placed a great deal of stress on the system. Out of the money puts that seemed harmless a few weeks ago proved troublesome just a few days later. The high volatility meant that more strikes were “in play” than normal in the days leading up to expiration. In a product like SPY, it is very unusual to see extrinsic value in strikes that are $10 out of the money in the days leading up to expiration, and it was typical to see extrinsic value in a wide range of large-cap ETF options this week. Wider, thinner, faster-moving markets also made it very difficult for those with expiring positions to roll them into ensuing weeks or months. That effectively locked many traders into expiring positions that they would have rather rolled. It seems logical that they would relish seeing those positions off their books.

As millions of contracts expire, and along with them the margin and haircut requirements on those contracts and their hedges, the entire equities ecosystem will feel some much-needed relief. There is an old, appropriate adage that states “trade when you can, not when you have to.” Many were forced to trade when they had to over the prior few weeks. Fewer outstanding positions in the market will hopefully allow more investors to be proactive than reactive in their decision-making.