WASHINGTON – It’s quadruple witching Friday on Wall Street, and Mr Market’s going nuts as usual. And so are the Big Bad Bears. During a quad-witching Friday, stocks tend to go nuts for a few hours until current options contracts expire mid-afternoon (2 p.m.) on the third Friday of each month. If stocks have been rallying recently, quad witching day tends to be bullish. But if Mr Market has experienced waves of selling – like this month – quad witching day tends to twist bearish.
Which direction do you think Mr Market is taking today? Need a hint? Check out our headline illustration above. Yeah. It’s one of those Big Bad Bears ready to pounce on unsuspecting small investors. Beware!
Quadruple witching and witching in general: What it is, what options can do
For those not familiar with the concept of “witching,” here’s a nice, short definition from Investopedia.
“Quadruple witching refers to a date on which stock index futures, stock index options, stock options, and single stock futures expire simultaneously. While stock options contracts and index options expire on the third Friday of every month, all four asset classes expire simultaneously on the third Friday of March, June, September, and December.”
Options are something we don’t talk much about here in this column because they can get way too complex. They’re essentially bets on the direction a stock will take over a set period of time. Each option “controls” 100 shares of stock, the old but still current definition of a “round lot” on Wall Street.
But unlike a common stock, if your option doesn’t hit its target up (a “call” option) or down (a “put” option), it expires worthless on the third Friday that marks its official expiration date. So, if you’re not a winner, you lose all your money.
Why would investors “gamble” on options when they can expire worthless?
If they can lose all their money, why would people do this? Well, options at their simplest are simple and even seductive. And more often than not, a bit dangerous.
Simply stated, save in rare instances of corporate bankruptcy, a healthy common stock pretty much never expires worthless, although it can certainly go down a lot. That’s something we all discovered (or re-discovered) this past March. But if your option fizzles out like a slow leaking balloon because you picked the wrong option, the wrong expiration date, or the wrong price to pay for it, you’ll lose all your money. Or most of it if you sell before it loses all its value. On the other hand, you can buy an option covering 100 shares of even an expensive stock for a lot less money that it’ll cost you to actually buy those shares. And you can still get the same, though proportional, ride if you place your bet just right.
Writing covered calls can provide income in your account. But, as always, there’s a catch
We rarely mention options here because they’re generally too dangerous for small investors, at least in this market.
But over the past few years, the one conservative option strategy – writing covered calls – has also become tough for small investors to deploy. It’s a strategy that can often defeat those Big Bad Bears. (But not always.)
Simply stated, you start out on this strategy by buying, or already owning, 100 shares of a given stock or a multiple of 100 shares. Generally, you bought these shares because you’re either bullish on the company or you’re buying the shares at a bargain before you think everyone else is going to get bullish and start buying the stock.
You then “write” (i.e., sell) a fresh new call option against the stock at a strike price (exercise price) reasonably higher than the current price of your shares. What this means, though, is that you’re sort of on the hook to the anonymous buyer of your call. If your stock goes nowhere, or just meanders around a bit until the option’s expiration date, the owner of your option watches it go worthless. At which point, you pocket the profit you just made by selling it to him. It’s almost like being one of those Big Bad Bears yourself. Except that you still own your shares. Your option holder got nothing for his bet.
The flip side…
On the other hand, if on or near options expiration date your stock gets feisty and blows up and above the option’s strike price, the call owner’s brokerage automatically “exercises” or “executes” the call, and you’re forced to sell your 100 shares to the call owner at the call’s set price. Which can actually end up considerably lower than its current market price.
If this happens, well, you lost the bet. If, however, your stock just sat there, or didn’t move very much, your option buyer lost his option money, you pocketed it, and now you can do this again.
Why covered calls are actually conservative. Other option trades may not be
In short, the covered call is an income strategy that often works. Otherwise, option trading is gambling, as far as we’re concerned, so we tend to shy away from it.
The problem with covered calls these days is that companies have permitted their shares to get so damned expensive, that you have to be able to afford 100 shares (which small investors mostly can’t) before you can start writing calls.
Even after Apple (trading symbol: AAPL) split its expensive shares recently, we still see each Apple share priced, in a currently sinking tech market, at just over $100 per share. Let’s call it $105 for now. That means that you need to plunk down $10,500 for the hundred shares you need to start deploying the covered call strategy. Which pretty much closes small players out of this game today.
We hear that the SEC may be considering lowering the number of shares owned before investors can play the covered call game. But like anything the Feds do, will this happen in our lifetime?
Back to quadruple witching and monthly options expiration antics
At any rate, this long digression gives you a clue as to what goes on when options expire. Stocks go crazy because computerized programs used by hedge funds, high-speed trading firms, and just plain old rich bigwigs go out into the market, search for calls (and puts) that are near their exercise price, goose them a little bit if they’re bullish, or sell them sharply if they’re bearish, to hit or “pick off” the strike prices of as many options as they can. This week, the Big Bad Bears are in control. But crazy moves up and down still occur anyway.
In the end, after the rich guys and bigwigs snage their quick, and in my mind, ill-gotten option exercise profits, they’ll flip the stocks they just called right back out again. And, because a large number of traded shares = a big profit, they’ll pocket a few fat moneybags full of $$$ while the picked-off small investors get caught holding the bag. Oh, well. We never said that capitalism didn’t have its predatory component.
Anyway, that’s what happens on triple witching or quadruple witching Fridays. It usually tends to accentuate the current up or down tendency of a great many stocks. (Not all stocks have options, BTW.) And that’s what’s happening today, which is why markets are getting hit by all those Big Bad Bears.
Have any “mad money”? The market’s lousy, but there might be some bargains out there now
In other news, it might be time to consider a little judicious buying, particularly in cyclical stocks and perhaps even in beaten down industrials. CNBC’s Jim Cramer opines on this topic at CNBC’s online site.
“CNBC’s Jim Cramer on Thursday recommended that investors start hunting for cyclical stocks that are at bargain rates and attracting interest from big fund investors.
“As a series of large IPOs consumed Wall Street’s attention this week, money managers trimmed holdings in their biggest tech gainers to raise cash to buy into the newly public companies, which put pressure on the broader market.
“The money is also moving to value cyclical plays like Dow Inc. [DOW], Caterpillar [CAT] and 3M [MMM}, Cramer said. Each stock rose about 2% during the session.
“‘I think it’s time to start putting cash to work. Instead of tech, though, I recommend picking up some of [the] historically cheap stocks that are being brought down by the entire averages,’ the ‘Mad Money” host said.”
Like Cramer, we think we’ve got at least one more week of general bearishness to go, as pre-election nervousness continues to ramp up. But October often turns out to be a bullish month, at least by the end of that month. So a little bit of buying here and there could be helpful if you don’t overdo it. We’ve picked into a few stocks, but not much. Next week, the worst may be yet to come. So we’re keeping most of our powder dry.
We’ll see how this brilliant plan actually works out. But first, let’s try to survive this quadruple witching Friday.
– Headline image: Today we offer you a lazy American black bear, a good symbol for recent trading action: down hard with a potential for nastiness. (Image via Wikipedia entry on bears, CC 2.0 license)