Listening to commentators talk about the stock market, it's easy to get lost in the jargon of Wall Street traders. Just yesterday, some analysts explained the rise in the S&P 500 (SNPINDEX: ^GSPC ) by linking it to what they called "quadruple witching." As much as that might sound like a holdover from Halloween a couple of months back, the witching concept actually does have a legitimate meaning in the financial markets, and it can have a marked impact on short-term conditions in the investing world. Let's take a quick look at what these often-used witching terms mean and what impact they can have on you.
When markets collide
To understand witching, you first have to know about how different markets affect each other. At the same time that stocks trade on various exchanges, options contracts and futures contracts that cover both individual stocks and broader stock indexes like the S&P 500 also allow investors to take positions in the various markets. These derivative positions don't involve buying or selling actual stock, but they give the investors who use them the same financial exposure to moves in share prices or stock market indices.
But one trait that all these derivative instruments share that stocks don't is that derivatives all have expiration dates. Futures contracts are tied to specific dates for delivery, with expiration dates after which buyers and sellers are no longer allowed to trade their contracts. Similarly, options contracts give their holders the right to buy or sell securities only for a specific period of time, with expiration dates that govern the last moment at which investors can exercise their options.
Typically, these contracts all expire in the last hour of trading on the third Friday of their expiration month. That final hour of trading is referred to as the witching hour.
Double, triple, quadruple -- oh, my!
The way that you get various multiples of witching depends on how many different types of derivatives are set to expire at any given time. During most months, you get double witching days on the third Friday of the month, when various options and futures contracts expire at the same time.
To get triple witching days, however, you generally need to have both stock index options, stock index futures, and individual stock options expire at the same time. That happens only once per quarter, in March, June, September, and December.
Just over a decade ago, however, exchanges came out single-stock futures, allowing traders to buy and sell futures contracts based solely on individual stocks. These futures add another witching to the total, making those quarterly dates quadruple witching days.
Why you should care
The thing about double, triple, and quadruple witching days is that derivatives traders often use the ordinary stock market to hedge their positions. As a result, as those traders work to close out their positions immediately prior to expiration, they can create a ripple effect on the stock market that in turn can create greater volatility than normal on the ordinary stock exchanges.
The takeaway for individual investors is that with institutions having a greater-than-normal presence in the markets on those days, you need to be particularly careful about the impact that professional traders might have on share prices. Anytime you go up against institutions, there's a big risk that you'll lose out if you're not careful. Your best move is to maintain your discipline in buying or selling stocks on witching days, or simply to avoid them entirely and choose less frantic sessions to make investment decisions.
Don't be afraid of the witch!
The one thing you shouldn't do, however, is let quadruple witching days scare you out of the stock market entirely. Unfortunately, millions of Americans have stayed out of the market for years and missed out on huge gains. In our brand-new special report, "Your Essential Guide to Start Investing Today," The Motley Fool's personal finance experts show you why investing is so important and what you need to do to get started. Click here to get your copy today -- it's absolutely free.