Study says retail investors are the losers from anomaly that costs more than $3.8 billion By Rob Mannix The fresh analysis, which builds on work done by the same team in 2023, shows that professional investors benefit from a pricing anomaly in S&P 500 index options that costs retail investors more than $3.8 billion a year. A study last September flagged an upwards jump in option prices on so-called witching days – the third Friday of the month, when many options settle – a pattern its authors said could only be explained by manipulation. In a newly updated version of the research, the authors use Cboe options data that classifies market participants by type to analyse the positioning of professional versus retail investors and market-makers. “We see evidence that professional customers are building up positions in the expiring options in the days before expiry and only then,” says Guido Baltussen, international head of quantitative strategies at Northern Trust Asset Management, a professor in finance at Erasmus University Rotterdam and one of the study’s authors. “That means these investors would profit from the pattern that we documented. And that’s in line with the manipulation story.” Baltussen and his co-authors, Paul Whelan, associate professor at the Chinese University of Hong Kong, and Julian Terstegge, a researcher at Copenhagen Business School, are calling for a change in settlement practices to make prices less vulnerable to potential manipulation. We see evidence that professional customers are building up positions in the expiring options in the days before expiry and only then Guido Baltussen, Northern Trust The research has received attention from the Commodity Futures Trading Commission and the Securities and Exchange Commission, Baltussen says. The Cboe data shows professional investors adding exposure in the relevant options in the days leading to expiration. Five days before expiry, the delta of professional investors is close to zero. Four days later, by the market close on the third Thursday of the month, the delta rises to more than 0.1. “That’s quite a significant number,” says Baltussen. The average delta of market-makers, for comparison, would be close to zero, he says. Delta represents the change in value of a firm’s option book as the price of the underlying moves up or down. A higher positive delta equates to a long market position, meaning professional investors – on average – are profiting from the elevated price when the options settle on the Friday morning. By contrast, in non-expiring options where no such profit opportunity exists, professional investors reduce their exposure over the same set of days. The losers are retail investors, the study indicates. “Retail investors are net delta negative and hence lose at least $3.8 billion a year due to the derivative payoff bias,” state the authors. Baltussen and his fellow researchers calculated the wealth transfer from professional to retail market participants based on the outcome if index options settled at the level of Thursday’s close. Third-Friday spikes In their prior work, the researchers found that settlement prices for S&P options traded at Cboe tended to be 18 basis points higher on the third Friday of the month. The study authors also observed an accompanying spike in equity index futures in the hours before market open. The futures price spike points to buying pressure that drives up the settlement price for the options, the researchers say, and they concluded that only market manipulation could explain the third-Friday pattern. The anomalies occur independently from fundamental news, for example, and grow bigger on ‘triple witching days’ — the third Friday of the quarter when index options, futures contracts, options on futures contracts and single stock options expire at the same time. Most S&P 500 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. The researchers in their study update also examined whether a specific type of hedging from market-makers could explain the witching day effect. For at-the-money options, the change in the delta of an option through time – referred to as charm – can increase sharply in the hours before expiration, plausibly leading to intense hedging in the overnight window. But Baltussen says such an explanation for the option price spike failed to convince. “We do see some evidence that points to charm hedging,” he says, “but not very significantly or substantially.” In fact, the data points to market-makers playing no obvious role in causing the spike. The group’s near-zero net delta exposure indicates that market-makers reduce risk to ahead of expiration. Time for change Baltussen and his colleagues argue in the working paper that settlement practices should change. “Current settlement design is inefficient,” they state, proposing instead that the settled derivative time for S&P options be moved away from the illiquid overnight period to Thursday’s close or noon on Friday. RELATED ‘Witching day’ price spikes point to options market manipulation – study Data reveals patterns that can be explained no other way, researchers say “Retail investors could be protected from these losses if settlement was moved to any time that follows liquid trading in the underlying.” Even if market manipulation had nothing to do with the spike in prices, the case for moving settlement would stand, Baltussen says. “Settlement after an illiquid window, as on Friday morning, opens up the possibility of manipulation and other effects, such as charm hedging, affecting price,” he says. “The wealth transfer is high, and you would like to avoid it.” Some options such as Euro Stoxx 50 options have midday settlement times and show no evidence of this type of pattern, Baltussen notes. A Cboe Global Markets spokesperson commented: “Preserving the integrity of Cboe’s trusted marketplaces and protecting investors is one of our highest priorities. Cboe takes any market abuse, including manipulation, seriously and maintains a regulatory program that surveils for unusual trading activity.” In a written statement responding to the study, a spokesperson for CME said the exchange continuously monitored trading activity and conducted targeted reviews to detect settlement and market disruptions. “If we identify violations of exchange rules, we stridently pursue enforcement actions against the offenders,” the spokesperson said. “Not all market movements, however, are the result of bad actors. We appreciate that the authors of the paper have acknowledged that the price movements they studied could be explained by bona fide market activity.” The SEC declined to comment. The CFTC did not respond to requests for comment before press time.
https://www.risk.net/investing/7958976/professional-investors-behind-witching-day-options-spike
Crappy paste and the graphics dropped, but aricle is paywalled.
https://www.risk.net/investing/7958976/professional-investors-behind-witching-day-options-spike
Crappy paste and the graphics dropped, but aricle is paywalled.
