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Double, Triple, and Quadruple Witching

Filed Under Beginner Options Trading 

 
By the way, you can always find out which contracts will be available for any stock going to www.cboe.com and then clicking on “Trading Tools” and then “Cycles and Strike Month Codes.”
 
You can also find similar tools at the homepage for the Options Industry Council (OIC) at www.888options.com. Click on “Tools and Literature,” “Pricing Calculators,” and then “Cycles.”
 
Double, Triple, and Quadruple Witching
Now that you understand option cycles and how the contract months are determined, let’s talk about the terms double witching or, more commonly, triple witching. These are days when multiple derivative products expire on the same day. For example, if stock futures, stock index options, and stock options all expire on the same day then that is a triple-witching day. Typically, stock futures expire on the quarterly expiration (the last month of each quarter) months of March, June, September, and December so triple witching occurs only in these months. Double witching occurs when any two of the three assets expire at the same time. Less commonly knows is quadruple witching, which occurs when single-stock future contracts expire on the same day as well. It is widely believed that volatility in the market is much greater on these days as traders scramble to close positions. The truth is that few professional traders wait until the very last day to close positions, so these witching days are probably not as disruptive as many believe. Still, it is worth knowing what these terms mean as you will definitely hear them once you start trading or investing in options.
 
Contract Size (The Multiplier)
In the first chapter, we said that options generally cover 100 shares of stock. In this section, we’re going to show you why we said “generally.” When options first start trading, the contract size is always 100 shares. This 100 share-sized lot is also referred to as the multiplier because that is the amount we must multiply the option premium by to find the total cost of the contract. For example, if a call option is asking $3, you will pay $3 * 100 = $300 (plus commissions). It is also the amount we must multiply by to find the total contract value. If you exercise a $30 call, you will pay $30 * 100 = $3,000 and receive 100 shares of stock. So the “contract size” and “multiplier” are two different ways of expressing the unit of trade of the option.
 
While all options start with a contract size of 100, there are corporate actions that can change that. The most common event is a stock split. Stock splits generally occur when the price of the stock is perceived to be too high, so the company will split the stock to bring down the price.
 
            A stock split is really a cash dividend, which means the company pays you a dividend in shares of stock rather than cash. With a 2:1 stock split, the company pays you one share of stock for each that you own thus doubling the number of shares you own.
 
However, because the company is paying a dividend (whether in cash or shares) the price of the stock must be reduced to reflect the fact that some value of the company has been paid out to shareholders. A stock split therefore will always increase the number of shares outstanding (and therefore in your account) and the stock price will always fall.
 
How many shares will you have and by how much will the stock price fall? These
questions are easy to answer once you understand the mechanics of a stock split. Any time a split is announced, it is always reported as the ratio of two numbers such as 2:1. If you take the first number divided by the second, you get the “split ratio,” which is 2 for this example. The number of shares will always be multiplied by this ratio and the stock price will be divided by the same number.
 
There are many types of splits with 2:1 being the most popular. However, you will also see variations such as 3:1, 4:1 and so on. We will refer to these as “whole number” splits since you always end up with multiple 100-share lots after the split. In addition to whole number splits, you may see “fractional” splits such as 3:2, 5:4, 8:7, and so on. Any split ratio where the second number is greater than one creates a fractional split. These types of splits increase the number of shares you own just as whole number splits; however, that new number will not be evenly divisible by 100. For instance, a 3:2 split means that you will receive 3 shares for every 2 that you have thus increasing the number of shares by 50%. If you had 100 shares prior to the split, you will have 150 shares after the split. A 5:4 split leaves you with 125 shares for every 100 shares you previously held.
 
For instance, assume ABC stock is trading for $180 per share. At this price, the company may think its share price is too expensive as it is difficult for many investors to buy shares, at least in round lots of 100, since that will cost $18,000. In order to bring the price per share down, the company may announce a 2:1 split. If you own 100 shares of ABC prior to the split, you will own 200 shares at a price of $90 after the split. Notice that we multiplied the number of shares by two (split ratio) and divided the price by two as well.
 
Because we doubled the number of shares but cut the price in half, the total number of dollars invested does not change. If you have 100 shares of ABC at $180, then the position is worth $18,000. After the split, you’d have 200 shares at $90, which is still $18,000 worth of stock.
 
A 3:1 stock split would give you 300 shares at a price of $60 per share after the split ($18,000 worth of stock). A 4:1 split yields 400 shares at a stock price of $45 ($18,000 worth of stock).
 
Now let’s take a look at some fractional split examples. If the same stock had a 3:2 split, then the split ratio is 3/2 = 1.5. If you had 100 shares prior to the split, you’d have 100 * 1.5 = 150 shares after the split and the price would fall to $180/1.5 = $120. Again, notice that after the split you still have 150 shares * $120 = $18,000 worth of stock. A 5:4 split provides a split ratio of 5/4 = 1.2 so you’d end up with 100 * 1.2 = 120 shares at a price of $180/1.2 = $150 per share. In both of these cases, you still own $18,000 worth of stock.
 
So a stock split doesn’t change the total value of your investment but only the way in which it’s packaged. It’s no different than when you exchange one $10 bill for two $5 bills. You have twice as many pieces of paper (shares) at half the value so the total value of your wallet hasn’t changed. When viewed in this light, stock splits aren’t really a big deal even though they are often met with much fanfare by the investing public. After a stock split, it is true that the company may create more demand by the public to own it and that certainly can put upward pressure on the price. However, the stock price is now twice as hard to move because there are twice as many shares outstanding, so there are drawbacks to splitting a stock. But regardless of whether stock splits are good or bad, they do occur and they can change the contract size.
 
To be continued,,,

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