European indices are re-aligning today as stock options, stock index futures and stock index options all expire, making for manic activity as volatility spikes and traders seek opportunities for arbitrage. With volumes expected to be up 170% and a surge in closing activity on the cards, algos are also coming under pressure to adjust. We speak to the market to learn just what ‘triple witching’ is – and why it matters.
Triple witching only happens four times a year – on the third Friday of March, June, September and December – and is essentially just a realigning of European indices. But it can make for some serious volumes, which in turn offers traders the chance to take advantage of arbitrage opportunities as the prices shift.
Potential impact
“The combination of these expiries can have a marked impact in the cash equity market as volumes spike. Trading activity increases as traders look to manage their positions often with the need to buy or sell the underlying security,” explained Matt Cousens, head of EMEA equities at BestEx Research, speaking to BEST EXECUTION.
“Most market participants will be affected by this as volume increases can cause spikes in volatility and there are material changes to the composition of volume curves, particularly in the last hour of the trading day – it’s a fairly significant event.”
And it’s bigger than usual this time around. “Today is quadruple because stock index futures and options and single stock futures and options are all expiring on the same day,” a buy-side equities trader told BEST EXECUTION this morning. “It’s not a headache, but there is big liquidity to the market, so everyone gets excited.”
For the buy-side, it’s not a major cause for concern but rather, an opportunity for arbitrage. “The rolls are already done for futures and options by now, unless you are happy to let them expire,” explained another buy-side head of trading, speaking anonymously to BEST EXECUTION.
“Volumes are massive though, so we use it as an opportunity to trade and take advantage of price dislocations due to ‘pinning’ in underlying options pricing or caused by delta hedging on the futures contracts. It creates a lot of opportunity for risk arbitrage. That’s why it’s always good to understand where the large open interests are on the underlying contracts.”
“Volumes are massive, so we use it as an opportunity to trade and take advantage of price dislocations.”
Risk vs reward
Although most are ready for the uptick in volatility, there’s always a risk when volumes are this high.
“It is a market event that people will be prepared for,” said one market participant, who asked not to be named due to client sensitivities. “Of course, if volatility was high and positioning is concentrated, then this can pose problems. Volatility is pretty benign at present though, so I do not see this being an issue.”
One impact today has reportedly been on the London Stock Exchange (LSE)’s Exchange Delivery Settlement Price (EDSP) auction, held at 10.10am on the third Friday of every month to calculate the EDSP of the FTSE 100. EDSP refers to the price at which exchange-traded derivative contracts are settled, and is used by exchanges to calculate the amount that each party owes at contract expiry.
According to one liquidity expert, speaking to BEST EXECUTION on condition of anonymity, the LSE EDSP auction this morning was notably busier than usual – and this can create its own risks.
“Every now and then people miss the auction, getting filled at a different price in continuous, which causes problems with the related derivatives position – it’s rare, but it can happen if people don’t use the right order types. Either way, it’s a big volume event and there have been occasions in the past whereby people (either through technical or timing issues) have sent orders intended for the EDSP and unintentionally traded in continuous instead. That’s why the LSE introduced the specific GFX time in force instruction [used to direct orders into the intraday auction].”
Looking ahead, another effect of triple witching is a major surge at the close, which is expected to be extremely busy today – creating increased operational risk for the Tier 1 institutions that account for much of the closing flow.
Algo adjustment
The high volumes both intraday and at the close mean that it is crucial for firms to adjust their algorithms in response.
“Liquidity events such as triple witching bring heightened volumes to our execution platform. We see a particular increase through LT, HT and PT in the intraday expiries and closing auctions. Although our VWAP and Target Close algorithms are dynamic, we still need to overlay with specific adjustments for the auctions,” explained Byron Griffin, head of market structure and liquidity solutions at Kepler Cheuvreux Execution Services (KCx), speaking to BEST EXECUTION. “Trading in auctions (intraday and the close) reaches 47% vs 20% on regular days.”
Most brokers will have specialist systems set up to manage this impact. “When it comes to triple witching, volume profiles and predicting auction volumes accurately are crucial,” stressed Griffin. “As with any sophisticated broker, you should have in place a robust process to manage this liquidity event.”
“When it comes to triple witching, volume profiles and predicting auction volumes accurately are crucial.”
For example, KCx has both a quant execution team and a quant research team, both of which have produced their own independent models to quantitatively estimate volume around these index events, which the firm then combined into one – which is then, as an additional layer of accuracy, monitored by the algo trading team, and then broadcast firm-wide for maximum transparency.
“These liquidity events result in us transacting a large increase of volumes throughout the day,” said Griffin. “What we’ve found is that through using a quantitative estimate of volumes changes, we can get a more accurate result than the traditional method, which tends to underestimate volume. We don’t like keeping that info internal only. This is why we publish these parameters and profiles through our API directly to clients real-time.”
BestEx Research is also tweaking its algos in preparation. “To accommodate the expected volume shift created by this event, we’ve made adjustments to our algorithms’ symbol-specific volume estimates. Most of our algorithms—including VWAP, Optimal (IS), Close, and POV—will be impacted by the changes,” the firm explained to BEST EXECUTION.
“After the trading day starts, our dynamic volume prediction model will continually adapt its forecasts throughout the day based on that day’s volume observations for those algorithms that incorporate real-time information.”
The firm expects today’s volumes to be approximately 170% above the usual ADV, while both the opening and closing auctions are also predicted to surge. “Intraday volume is likely to be more front-loaded and U-shaped, with the volume curve exhibiting a more front-loaded profile,” said BestEx Research.
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