As Trillions Of Options Contracts Expire Friday, U.S. Stocks Are Set For Wild Swings

As option contracts tying trillions of dollars in securities are set to expire on Friday, it is expected that U.S. stocks could see more wild swings over the coming days as the index is likely to lose a buffer that was helping it to keep from breaking out of a tense trading range in the past few weeks.

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According to Goldman Sachs Group (GS), the "triple witching" event slated for Friday will see an expiration of $2.8 trillion in options contracts, with an average value of $123.66.

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In triple witching, as it is known in the industry, the right to sell one's underlying equity futures or options contracts based on a stock or index, as well as an exchange-traded fund, expires on the same day. Options contracts can expire in the morning or in the afternoon, depending on the type of contract. As a rule, this happens roughly once every quarter, four times a year.

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These kinds of days often coincide with volatility in the markets as traders try to get their losses cut or earn their winnings by exercising "in the money" contracts.

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The expiration of a number of contracts that have helped to suppress volatility in the equity market could lead to even wilder swings in future sessions, according to a top derivatives analyst at Goldman Sachs.

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Trade Algo obtained a note by Goldman managing director and top derivatives strategist Scott Rubner saying Friday's expiration of options could "remove the 4k pinner that has kept a lid on big moves." A big move in either direction would make the S&P 500 more susceptible.

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Data from Trade Algo shows that the S&P 500 has been trading within a relatively narrow channel of 400 points, which has been bounded on the downside by 3,800 and on the upside by 4,200 points since the beginning of the year.

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There is a correlation between these levels and some of the most popular strike prices for options tied to S&P 500, according to the data contained in Rubner's report. It is defined as the level at which someone is able, but is not obligated, to buy or sell securities, depending on the type of option they own. Strike prices are determined by the level at which a seller or buyer of an option has the ability to buy or sell a security.

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There's no coincidence there. A growing number of traders have been trading options nearing expiration, also known as zero-day to expiration (ZDTE) options. It has contributed to keeping stocks inside narrow ranges while fueling intraday swings within those ranges, a pattern that has been compared to a "game of ping pong" by some traders.

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S&P 500 contracts tied to 0DTEs account for more than 40% of the average daily trading volume, according to Goldman Sachs.

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Brent Kochuba, founder of SpotGamma, a provider of data and analytics about the option market, says trading in 0DTEs prevented the S&P 500 from falling below 3,800 this week.

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In an article published by Kochuba and others in Trade Algo, analysts suggest that this is one of the reasons why the Cboe Volatility Index, otherwise known as the Vix or Wall Street volatility gauge, has been relatively quiet compared with the ICE BofAML MOVE Index, an index designed to measure implied Treasury volatility.

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In a surprise move, the MOVE index soared to its highest level since the 2008 financial crisis earlier this week because of volatility in Treasury bonds. The VIX barely breached 30 this week, a level it last reached in October.

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The situation could change starting Friday, however, according to some.

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It isn't just Friday that has large swaths of option contracts expiring next week. In tandem with the Federal Reserve's announcement of its latest interest rate hike on Wednesday, many contracts linked to the VIX will expire.

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In an interview with Trade Algo, Kochuba said that 50% of all Vix open interest expires on Wednesday.

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Alon Rosin and Sam Skinner, two equity derivatives experts at Oppenheimer, say that this could lead to the Vix "catching up" with the MOVE, resulting in a sharp stock selloff.

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It's likely that more volatility will hit the equity market in the near future, and the VIX is underpricing it," Skinner said in a call with Trade Algo.

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She also predicted that "volatility levels will remain elevated" heading into next week's Fed meeting in emailed comments to Trade Algo.

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According to the CME's futures market, futures traders expect the Fed to raise rates by 25 basis points, but trader estimates still put a 20% chance of the Fed leaving rates alone.