IV crush occurs when an options contract’s extrinsic value sharply declines following significant corporate events, such as earnings announcements. Unfortunately, this implied volatility crush catches many new options traders off guard. Buyers of stock options before earnings release is the most common way new options traders 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, but they also lost all their money.
We will break down IV crush so you can identify it before it crushes you.
What Is IV an Crush?
The IV crush is a term traders use to describe a scenario in which implied volatility decreases rapidly. Typically, this occurs after an event has taken place, such as the announcement of earnings or the date of an FDA approval. Implied volatility is a metric that forecasts the likelihood of price movement in a security. IV is quite useful in projecting a few things, such as future price moves, supply and demand, and pricing options contracts.
Additionally, several factors influence the calculation of implied volatility. However, supply, demand, and time value are two major determining factors.
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.
Experiencing an 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.
Furthermore, when the perceived uncertainty of a stock’s price increases, demand for option contracts in that security also rises. That was a mouthful, I know.
When this plan is implemented, the extrinsic value of the options increases. And this translates to a rise in implied volatility. Typically, this scenario unfolds as the company’s earnings date approaches.
Typically, an IV crush occurs when the market transitions from a period or event of unknown information to one of general information.
In simpler terms, IV rises in anticipation of an event and falls after the event. A notable example of this is an upcoming earnings event.
IV Crush Example
$CPB has a very strong volatility ramp into earnings and then a nice crush after the earnings report.
How Do You Stop an IV Crush?
How do you stop an IV crush? It would be best to buy when implied volatility is low. Or you can sell options around earnings. Remember that selling options is a highly risky strategy. However, since 80% of options expire worthless, the sellers usually come out ahead.
IV Crush After Company Earnings
Companies are often shrouded in secrecy, yet we get a glimpse under the veil on earnings day. Public companies release their earnings quarterly, and market participants eagerly await this date.
This is why implied volatility in options tends to pick up before the “big” announcement and decrease significantly immediately after the announcement.
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 pushes 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.
IV Crush Earnings Example
Let’s use stock ABC as an example. In this scenario, ABC trades at $100 the day before its earnings announcement. 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 the earnings announcement? 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 sell 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 take no action. You’re probably wondering about the logic behind that decision.
She reviewed prices around previous earnings announcements and noticed that stock ABC typically moves an average of 2%. For this reason, she believes her straddle is valued fairly and takes no action.
$CARA Earnings Chart
Check out $CARA before earnings. IV is shown on the lower portion of the chart. I’d like you to know 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. Uncertainty falls unless the company plans a major event (i.e., putting itself up for sale). And this is where the magic happens. Because humans tend to prefer certainty, reducing uncertainty decreases volatility.
Now, paying attention to what I have to say is important. 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 negative report provides us with valuable insight into the company’s operations.
Regardless of the direction, this information enables a stock to be priced differently. Either way, uncertainty is reduced and implied volatility drops. And this couldn’t be truer in the month containing earnings expiration.
Final Thoughts on IV Crush
As you can see from the above, IV Crush is a crucial component 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, we will teach you in our trading community.
Frequently Asked Questions
What does IV crush mean in options? An IV crush happens when the implied volatility of a security drastically decreases. This can happen due to company news, earnings, and economic events.
One of the most common ways to benefit from an IV crush is to sell options contracts on a company before it reports earnings. This is a way for traders to profit if they believe the implied volatility is too high.
A VIX crush happens when there is a sudden drop in implied volatility on the VIX. This usually happens after a major scheduled event.
The IV rush can be calculated by measuring the difference between the front week and the back month, as well as the vega of the options strategy. Then, multiply it by the IV difference.
The higher the IV (implied volatility) of an option, the higher the premium of an options contract. This creates a bigger underlying move in the security.
