Just as Wall Street traders are eager to take advantage of the Federal Reserve's interest rate cut, Friday's U.S. stock options expiration date may bring more shocks to the market.

This quarter’s “triple witching” will see about $5.1 trillion worth of options tied to individual stocks, indexes and exchange-traded funds expire, according to estimates by derivatives analytics firm Asym 500. While the risk is sometimes exaggerated by Wall Street, options events are notorious for causing sudden price moves when contracts expire and traders roll existing positions or start new ones.

This quarter’s expiration comes at a critical time for markets to price in the first rate cut since the coronavirus pandemic, following the Federal Reserve’s decision this week to cut interest rates. The Cboe Volatility Index, or VIX, a gauge of expected swings in the S&P 500, remains above levels seen before the market slide in late July and early August, suggesting investors remain cautious.

"Triple witching could 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 thinks about the Fed cutting, Friday's large options expiration will add to the volatility."

The options expiration also coincides with a rebalancing of indexes including the S&P 500, suggesting a group of investors will be actively trading around these positions, with daily volume typically the highest of the year. Dell Technologies Inc, Erie Insurance Corp and Palantir Technologies Inc will replace Etsy Inc, Bio-Rad Laboratories Inc and American Airlines Group Inc in the S&P 500 before the market opens on Monday.

Tanvir Sandhu, chief global derivatives strategist at Bloomberg Intelligence, said most of the open interest in put and call options is concentrated around 5,500 on the S&P 500. The index has largely stayed within 200 points of that mark in recent weeks, sparking speculation that the tight trading range is the result of options activity that has made the index a battleground between investors and market makers.

Seasonal weakness has played a role in the past, with the September "Triple Witching" typically causing a stock market rout the following week. Since 1990, the S&P 500 has fallen an average of 1.1% in the week following September options expiration, according to the Stock Trader's Almanac. During that period, there have been only four exceptions when stocks have risen across the board: in 1998, 2001, 2010 and 2016.

Still, the ratio of calls to puts in expiring options positions is 4:1, which helped stocks post their best five-day winning streak of the year last week, said Brent Kochuba, founder of options platform SpotGamma. Given that Nvidia Corp. (NVDA) has higher call options volume than other companies in the market, this should be a "catalyst for further gains in stocks," he said. "The recent stock market rebound has reduced a large number of put options positions, which has eased downside hedging pressure ahead of the FOMC meeting and VIX expiration," Kochuba said. "The reduction in hedging pressure makes it possible for more volatility next week."

That’s why traders monitor Wall Street traders who are on the other side of options trading, buying and selling stocks to maintain a market-neutral stance. According to Kochuba, if the S&P 500 falls below 5,600, these traders are “short gamma” and will have to start selling stocks below that level in order to remain neutral.

Now, with many contracts expiring, the key question is whether investors will move back into protective puts on worries about economic growth or chase this month’s market rally by buying call contracts as the S&P 500 hovers near a record.

“If a Fed rate cut is interpreted as too little too late, then protective puts could be bought, which could drag the market lower if traders are forced to hedge,” said Thompson of Little Harbor Advisors. “But if a rate cut is well received ... that would support stocks.”

The article is forwarded from: Jinshi Data