IV crush is when an options contract’s extrinsic value sharply declines following significant corporate events such as earnings. Unfortunately, this implied volatility crush catches many options trading beginners off guard. Buyers of stock options before earnings release is the most common way options trading beginners are introduced to the Volatility Crush.
Not only are they shocked to find out that they didn’t make any money on their option – even though the stock went in their favor – they lost all their money!
This blog will detail IV crush, so you can identify it before it crushes you.
Table of Contents
What Is Implied Volatility (IV)?
Implied volatility is a metric that forecasts the likelihood of movement in a security’s price. IV is quite useful in projecting a few things, such as future price moves, supply and demand, and pricing options contracts.
Also, several factors come into play when calculating implied volatility. But two of the major determining factors are supply and demand; along with time value.
$CPB has a very strong volatility ramp into earnings and then a nice crush after earnings report.
Implied Volatility & Options Trading
Implied volatility is often used to price options contracts—high implied volatility results in options with higher premiums and vice versa. It’s where we determine IV crush.
As you probably already know, we use two components to value an option contract; intrinsic value and extrinsic value. If you’re new to options and this sounds Greek, the extrinsic value represents the “risk premium” in an option. Our website has an options course; you can check it out for more information.
Furthermore, when the perceived uncertainty of a stock’s price increases, we see a rise in demand for option contracts in that security. That was a mouthful, I know.
When this scenario happens, the extrinsic value of the options increases in value. And this translates to a rise in implied volatility. Typically, this scenario plays out as a company’s earnings date gets closer.
What Is Implied Volatility Crush?
The IV crush is a term traders use that describes a scenario in which Implied Volatility decreases very quickly. Usually, this happens after an event has passed, such as earnings, or an FDA approval date, for example.
When Do We Commonly Experience an IV Crush?
Typically, an IV crush happens when the market goes from a period or an event of unknown information to a period or an event of general information.
In simpler terms, IV rises in anticipation of an event and falls after the event. I would say the best example of this is an upcoming earnings event. We tend to keep an eye on these types of things in our live trading room.
IV Crush After Company Earnings Are Released
Companies are veiled in secrecy, yet we get a glimpse under the veil during earnings day. Public companies release their earnings every quarter, and market participants eagerly anticipate this date.
This is why implied volatility in options tends to pick up before the “big” announcement and decrease significantly immediately after the announcement.
Generally speaking, if the market participants think the actual earnings will be higher than expected, they will buy calls hoping to profit from the announcement.
Alternatively, they will buy puts if they think the earnings will be lower than expected. Once again, the underlying reasoning is the same; they hope to profit from the announcement.
In other words, the combination of call and put buyers push up volatility in anticipation of actual earnings “surprise.” Finally, one earnings day comes, and earnings are released. These trades are closed – and closed very quickly.
The combined result of the selling lowers volatility – hence, The IV Crush. However, a striking feature of all this selling is a steep decline in the option’s value.
How Do You Stop an IV Crush?
How do you stop an IV crush? You should buy when implied volatility is low. Or you can sell options around earnings. Remember that selling options are extremely risky. But since 80% of options expire worthless, the sellers usually sit pretty.
An Example of an IV Crush During Earnings
Let’s use stock ABC as an example. In this scenario, ABC trades at $100 the day before earnings. With one day to expire, the straddle can be bought or sold for $2.00. The market expects a 2% move the next day or earnings day ($2.00/$100 = 2%).
Conversely, what if ABC stock had a straddle price of $20 the day before earnings? That means the market expects a 20% move in earnings (($20/$100 = 20%).
Based on the two scenarios above, even rookie traders quickly realize the vast difference between the market’s expectations for earnings.
And if you were the trader lucky enough to spot the 20% scenario and sold the straddle before earnings, you’re golden. Theoretically, your position is still a winner even if the stock moves less than 20% on earnings day.
On the other hand, in the 2% scenario, the trader may do nothing. You’re probably wondering about the logic behind that decision.
She looked at prices around previous earnings announcements and noticed stock ABC moves an average of 2%. For this reason, she believes her straddle is valued fairly and does nothing.
Check out $CARA before earnings. IV is shown on the lower portion of the chart. Note how it behaves around earnings dates. When IV spikes, options traders look to sell options and capture the premium when it drops. This is also known as IV crush.
Good or Bad, Earnings Matter
Whether the earnings release brings us good, bad, or even new information, this time allows us to re-value the stock. And uncertainty decreases unless the company is planning some major event in the future (i.e., putting themselves up for sale). And this is where the magic happens. Because humans love certainty, decreasing uncertainty decreases volatility.
Now it is important to pay attention to what I have to say. First, the underlying options still experience a volatility crush when stocks make large moves down after earnings. This seems counterintuitive because equities tend to be inversely correlated to fear.
Take, for example, the S&P 500. Normally when the S&P goes down, we expect VIX to go up. However, this is not the case with earnings. So even a bad report gives us valuable insight into the company’s operations.
No matter the direction, this information allows a stock to be re-priced. Either way, uncertainty is reduced and implied volatility drops. And this couldn’t be more true in the expiration month containing earnings. We do hunt for volatility to trade with our stock alerts weekly!
As you can see from the above, IV Crush is an important part of options trading. In general, earnings volatility is a dynamic event with many moving parts. Luckily, it offers vigilant traders many opportunities to profit.
If you want to learn to trade the volatility crush, Bullish Bears has an extensive collection of relevant material – not to mention new options trading courses on our website.