This Friday the listed derivative markets will experience the event known as "Triple Witching." So how much do you know about this event and how it could impact your investments?

Here's a look at derivative expirations and how they affect you, as an investor, and how you can try to capitalize on related trading opportunities.

What's Triple Witching?

The term goes back to the 1980s, when index options (such as the S&P 500 "SPX"), index futures and stock options all expired on the same date at the same time. More recently, single stock futures were added to commodity exchanges, turning the event into "Quadruple Witching."

Typically, all of these derivative contracts stopped trading on the third Friday of the month and are valued as of the settlement or closing prices on that day. The CBOE has an excellent expiration calendar that options traders use and you can find on the CBOE Web site.

What you need to know: In 1987 there was a systemic breakdown in the markets (commonly referred to as the 1987 Crash) and many experts attributed the cataclysmic drop in the global stock markets to a popular strategy called portfolio insurance.

Portfolio insurance tried to ensure that the value of a portfolio did not go below some minimum level. In order to achieve this desired result, the portfolio manager would short-sell index futures. This led to a cascade of futures sell orders, which, in turn, impacted the stock and index options markets.

As a result of those events, several safeguards were put into effect over the next few years.

First, trading limits or "circuit breakers" were established on SPX futures. When the trading limit is reached (it's currently plus or minus 60 SPX points), then there is a cooling-off period whereby no futures can be traded in excess of the limit.

Second, the SPX index options, which were traded until the end of the expiration day and were valued as of the close (referred to as "PM" options), were modified so that the options ceased trading the end of the day prior to expiration and the settlement value was calculated at the open (referred to as "AM" options).

Lastly, derivative contracts, which were mostly available on a quarterly cycle (March, June, September, December expiration), are now readily available on a monthly cycle.

The effect of these changes was to dramatically reduce the impact of the Triple Witching trading and expand derivative trading over more expiration dates. However, in today's world, the quarterly Triple Witching day tends to have more volume associated with its derivative contracts and can lead to more volatile markets.

What to Expect

Now more than ever, we have huge cross linkage between stocks, options, futures and ETFs. With the exception of stocks and non-leveraged ETFs, all of the other securities and derivatives offer leverage.

Furthermore, we now have far more money being actively traded by hedge funds and day traders than ever before. As a result, there are more eyes that focus on expiration now than we did in 1987.

Finally, the effects of expiration now stretch over several days, instead of just one. So here is what you can expect to see:

  • Index activity should get a little active on Thursday (as it did on Wednesday), immediately preceding the AM expiration of options.
  • A late flurry of trading is likely to occur on Friday's close, as market participants look to "square" their positions (i.e., match-off long and short exposure) or "pin" stocks (see below).
  • On next Monday's open a "mirror image" effect could occur. This is a term I coined to represent the equal and opposite action, which occurs in the early part of the trading day on the day following expiration, versus the movement that occurs in the late part of expiration day.

    For example, a late expiration sell-off could be met with early buying activity the following trading day. Note that this mirror image effect could be short-lived and should be considered within that context.
  • Indexes, stocks and options could get pinned or locked to strikes at expiration. This is an attempt for options (puts or calls) sellers to have the options expire to as close to zero as possible, by insuring that the underlying stocks or indexes are as close to at-the-money levels as possible.
  • How You Can Trade Expiration

    There are several ways you can read the action going into expiration to try to capture a short-term trading gain. Here are a few:

  • The open interest for SPX March 800 strike options, as of the close last Friday, were 153,020 calls and 188,572 put contracts. These levels represented the largest amount of open interest in the SPX March 2009 option series.

    Additionally, the SPX March 750 strike options, as of the close last Friday, had 163,540 calls and 170,767 put contracts open. Both of these strikes are pretty close in total open interest (calls plus puts).

    The SPX closed at 756.55 last Friday. We began the week with a tremendous amount of pressure being applied to the market for the AM settlement on this Friday's expiration for the SPX to close at or around 750. However, as we progressed during the week and the market continued to drift higher, then it became more likely that the SPX would gravitate toward 800 by AM expiration. By Thursday we will have a better idea how that will play out.

    If you're looking for a trade off of expiration, then consider using the SPDR S&P 500 ETF (SPY) as 1 SPY equals approximately 1/10 SPX.
  • The market move I just described for index options can also be applied to single stock options, which are PM settled on expiration day.

    Take a look at IBM (IBM). Here's the total amount of open interest (calls plus puts) for IBM expiration, as of last Friday: with an 85 strike, there were 24,230; with a 90 strike, there were 25,661; and, with a 95 strike, there were 18,273. The stock closed at $90.36 on that day.

    There will be pressure for IBM to close at the 90 strike, but if the stock rallies, then the stock could close as high as 95 by expiration close.

    Conversely, if the rally stalls, then IBM could find its way down to 85 for expiration. Look to see how the option open interest and stock price for IBM progress as we get closer to expiration to see if an expiration trade could occur.
  • Try to take advantage of the mirror Image effect. Should the markets rally in the last half hour on expiration day, a trade to short the market with ETFs could occur near the close on Friday.

    In that case, if you short index ETFs on the close on Friday, then the trade would be to cover shorts in the first half hour on Monday.

    Alternatively, should the markets sell off in the last half hour on expiration day, a trade to go long the market with ETFs could occur near the close on Friday. Under that scenario, if you buy index ETFs on the close on Friday, then the trade would be to sell positions in the first half hour on Monday.
  • Your Homework

  • Observe the market's activity and bias in the run-up to and through the point of expiration this Friday.
  • Identify opportunities to trade stocks or ETFs based on options strike pinning/locking.
  • Identify opportunities to trade a "mirror image" expiration.
  • At the time of publication, Rothbort was long the SPX, although positions can change at any time.

    Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele.

    Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities.

    Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Term Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University.

    For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at www.lakeviewasset.com. Scott appreciates your feedback; click here to send him an email.

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