Wall Street’s $5.1 trillion Triple-Witching is the next market test

(Bloomberg) — Just as Wall Street traders grapple with the Federal Reserve’s interest rate cut, Friday’s U.S. options expiration threatens to roil the market further.

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The quarterly “triple magic” will result in the board losing about $5.1 trillion worth of options tied to individual stocks, indexes and exchange-traded funds, according to an estimate by derivatives research firm Asym 500. Although the risk is sometimes exaggerated by Wall. Street players, the options event has a reputation for causing sudden price movements as contracts disappear and traders rotate existing positions or start new ones.

This quarter’s expiration comes at a crucial time 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 is less than 1 percent from its record high, the Cboe Volatility Index, or VIX — which measures the expected swings in the S&P 500 — remains above levels from before the market crashed in late July and early in August, suggesting investors are still somewhat cautious.

“The triple whammy is likely to inject more volatility into the market — we just don’t know in which direction,” said Matt Thompson, co-portfolio manager at Little Harbor Advisors. “Whatever the market’s view of a Fed rate cut will be exacerbated by a large options expiration on Friday.”

Once again, options expiration coincides with the rebalancing of benchmarks, including the S&P 500, suggesting plenty of investors will be actively trading around those positions, with single-day volumes typically among the highest of the year. Before the market opened 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.

Most of the open interest in both puts and calls is concentrated around the S&P 500’s 5,500 level, according to Tanvir Sandhu, global chief derivatives strategist at Bloomberg Intelligence. The index has largely held at the 200-point threshold in recent weeks, fueling speculation that the tight trading range was a function of options activity that turned it into a battle line for investors and market makers.

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Weak seasonality has also played a role in the past, with the triple whammy in September usually followed by an equity loss the following week. Since 1990, the S&P 500 has fallen an average of 1.1 percent in the week after September options expire, according to the Stock Trader’s Almanac. There have been only four exceptions where stocks posted overall gains over that period: 1998, 2001, 2010 and 2016.

That said, the size of expiring options positions is 4-to-1 in favor of calls versus puts, which helped the stock deliver its best five-day period of the year last week, according to Brent Kochuba, founder of the options platform SpotGamma. Given that Nvidia Corp. trades with a large number of calls compared to the rest of the market, this should serve as a “catalyst for future growth in the stock,” he said.

“The recent rally in stocks has reduced large short positions, which has eased bearish hedging pressure in the FOMC meeting and VIX expiration,” Kochuba said. “This reduced hedging pressure allows for more potential volatility in the coming week.”

That’s why traders monitor Wall Street dealers on the other side of options trades, who buy and sell stocks to maintain a neutral position against the market. Those dealers are “short gamma” if the S&P 500 slips below 5,600, according to Kochuba, and to stay neutral they’ll have to start selling stocks below that level.

Now, as many contracts expire, the crucial question is whether investors will rebuild their investment holdings to hedge against growth concerns — or watch the market rebound this month by buying S&P 500 call contracts near a record high.

“If the Fed’s rate cut is interpreted as too little too late, protective bids may be bought, which could then drag the market down if dealers are forced to hedge,” said Thompson of Little Harbor Advisors. “But if the cuts are well received … that would support stocks.”

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