Data reveals patterns that can be explained no other way, researchers say witching day manipulations By Rob Mannix. Is someone manipulating options markets on expiration days? A controversial new study says the evidence suggests they are. Researchers have found signs in the settlement pricing of options that point to market manipulation with the potential to cost hedgers billions every year. Looking at futures data from February 2003 to December 2021, researchers from Robeco, the Chinese University of Hong Kong and Copenhagen Business School identified a price spike in equity index futures in the hours before market open on the third Friday of the month – the day when many options expire, also nicknamed ‘witching day’. The spike points to buying pressure that pushes the settlement price for S&P index options 18 basis points higher on those days, the researchers say, systematically benefitting market participants that are short puts and long calls. “US equity derivative payoffs are biased,” the study’s authors state bluntly. The researchers tested different theories for why the spike should appear and concluded that only market manipulation seems able to explain its existence. Now they plan to share their findings with US regulators. “The impact is huge,” says Guido Baltussen, Robeco’s head of factor investing, co-head of fixed income and a professor in finance at Erasmus University Rotterdam, who participated in the research. “It’s a highly predictable return pattern that you can exploit. The wealth transfer is really sizeable.” S&P options settle at the so-called special opening quotation price, or SOQ, calculated using the first reported trades of the day in constituent stocks and usually published around 30 to 45 minutes after market open. It’s a highly predictable return pattern that you can exploit. The wealth transfer is really sizeable Guido Baltussen, Robeco On third Fridays, the SOQ is consistently higher than the previous night’s index closing value, the research shows. The difference hints at overnight trading that pushes the SOQ higher. The effect occurs only on expiration days, the data shows. “A persistent positive bias exists on days when it MATTERS,” the authors write in a working paper (their use of capitals). What’s more, the effect grows bigger on so-called ‘triple witching days’ — the third Friday of the quarterly cycle, when index options, futures contracts, options on futures contracts and single stock options expire at the same time. On those days the SOQ reaches nearly 27 basis points higher on average versus the previous night’s close. To gauge what the effect means for market participants, the researchers compared actual option payoffs with hypothetical payoffs, which they calculated using Thursday’s index closing prices – as if overnight trading had not occurred. The difference points to a wealth transfer of about $3.8 billion a year, they reckon – from market participants that are long puts and short calls to those who are short puts and long calls. The figure represents a lower bound, the researchers say, because it ignores the effect in futures markets, options on futures, exchange-traded fund (ETF) options and other index derivatives. Data from Risk.net’s Counterparty Radar service, which tracks the over-the-counter trading activity of US mutual funds and ETFs – a universe of roughly 12,000 funds – suggests that buy-side firms would be likely losers from the imbalance. These investors bought $38.5 billion more notional in S&P index puts than they sold in the second quarter of 2023 and sold $24 billion more calls than they bought. Academics and industry practitioners have long debated a similar and also surprising pattern in S&P futures – that overnight returns beat returns intraday. The new study is the first to examine price moves specifically around option expirations. Overnight buying Futures data shows a spike in prices on third Fridays that emerges in the early hours during premarket trading, peaks at 9:30am US Eastern time and reverses during the following day, the researchers found. “Overnight returns on third Fridays are an order of magnitude larger than we should expect,” they state. Third Friday intraday returns, conversely, are “abnormally large” and negative. One possibility would be that market participants are buying index futures overnight such that dealer hedging in the underlying stocks at the open pushes the SOQ up. Alternatively, firms could be trading individual stocks overnight such that hedging drives the price of index futures higher. Overnight returns on third Fridays are an order of magnitude larger than we should expect Guido Baltussen, Paul Whelan and Julian Terstegge Expiration days are “one of the most important days in financial markets – maybe the most important”, Baltussen says. “The question is: why would that structural buying pressure just before expiry be there? That’s the puzzle.” Baltussen and his colleagues – Paul Whelan, associate professor at the Chinese University of Hong Kong, and Julian Terstegge, a researcher at Copenhagen Business School – tested several theories that could potentially explain the pattern. Fundamental news plays no role in the timing of the spikes, they concluded. “The effect is there and just as strong regardless of whether there was an earnings or macroeconomic announcement or not,” Baltussen says. Nor does a phenomenon known as pinning explain what’s happening. As options approach maturity, market-makers adjust hedges with greater frequency and the related trading can cause stock prices to cluster around the nearest strike. Strike prices for S&P options follow $5 increments. But prices for stocks and futures on expiration days are evenly spread, rather than bunching closer to strikes. “It’s close to a uniform distribution,” Baltussen says. “There’s no pinning in the prices.” Market-makers nudging bids and offers higher or lower to manage risk in their own book could plausibly explain a price spike followed by a reversal, the researchers say. But such behaviour usually aligns with periods when liquidity is scarce. In other studies, inventory-driven price spikes and reversals correlate to higher volatility and typically follow spells of poor market returns. When the researchers cross-checked the timing of the third Friday spikes against past returns they found no such correlation. Instead, the evidence points to market manipulation as the most likely explanation for what’s happening, the researchers say. Trading in the premarket ahead of expiration days is notable, Baltussen points out, because liquidity at that time is thin and therefore transaction costs are higher. Meanwhile, the researchers found no similar “structural price pattern” around the market close – a time when some other options contracts settle but when markets are more liquid and manipulation would be harder. Sophisticated market participants with short positions in puts or long positions in calls might gain from manipulating the index price immediately preceding settlement Guido Baltussen, Paul Whelan and Julian Terstegge “Sophisticated market participants with short positions in puts or long positions in calls might gain from manipulating the index price immediately preceding settlement,” the researchers state. Arriving at a firm conclusion on manipulation, though, is tough, Baltussen acknowledges. “These are highly liquid markets and it’s hard to prove.” That said, “regulators should critically examine the SOQ”, Baltussen says, adding similar patterns are evident in other options that also fix settlement prices after periods of illiquid trading. “Maybe options should not settle after the most illiquid window of the market, which is overnight,” he says. Garrett DeSimone, head of quantitative research at data provider OptionMetrics, says he “wouldn’t be surprised” if the paper draws the attention of regulators. Equally, though, the anomaly could simply fade if hedge funds formulate strategies to capitalize on it, he suggests. Indeed, the researchers calculated that trading around the expiration day effect would be profitable. A strategy that went long index futures at the Thursday close and switched to a short position at Friday’s open would return 24bp on average each expiration day, net of transaction costs. Investors that are systematically long puts might also adjust their trading to roll options positions earlier, DeSimone points out. A source at an options market-maker tells Risk.net the anomaly is “interesting” but says it might be explained by market participants rolling their exposure to maintain a hedged portfolio by trading in the underlying index components so as to precisely trade at the settlement price, a practice sometimes called matching the print that occurs on settlement days. The source is skeptical market participants could meaningfully influence index prices, given the liquid nature of the market.
This analysis is completely asinine. There are tons of different market makers and functional dealers in the index option markets- and the hedge instruments are the most liquid in the world. However, when the traditional positioning is buying put / selling Call- as it *generally* still is if you are talking about the serial and quarterly expiries- then you are going to witness the literal unwinding of hedges in real time... as "real time" literally decays to zero and the holders of said options are left with NOTHING but naked short deltas - if they don't buy them back contemporaneously into the settlement time. This is just a function of positioning and option hedging mechanics. Nothing more. While it may be convenient to think that Ken Griffin is sitting somewhere cosplaying as Mr. Burns from the Simpsons and f***king over the universe of institutional options traders to the tune of... 18 bps; it's probably more likely that none of the many different dealers prefer to carry their net hedge beyond the life of the option portfolio it's paired off against. I mean, come on. And when is this impact going to be most "impactful?" Premarket? (Like during an SQQ where there is less traditional liquidity?) Do we see this "18 bps" every single options settlement? No? Why not? (Again.. all basic, common sense answers.) Go investigate Congress for insider trading; better use of time and effort