IV crush is the phenomenon whereby the extrinsic value of an options contract makes a sharp decline following the occurrence of 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 what IV crush is, so you can identify it before it crushes you. Watch the video above to gain a better understanding.
Implied volatility is a metric used to forecast 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, we have several factors that come into play when calculating implied volatility. But two of the major determining factors are supply and demand; along with time value.
Implied volatility is often used to price options contracts. High implied volatility results in options with higher premiums and vice versa.
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 to you, the extrinsic value represents the "risk premium" in an option. We have an options course on our website; you can check out for more information.
Furthermore, when the perceived uncertainty of a stock's price is increasing, 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 get's closer.
The IV crush is a term used by traders 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.
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 known information.
In simpler terms, IV rises in anticipation of an event and falls after the event. Personally, 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.
Companies are veiled in secrecy, yet we get a glimpse under the veil during earnings day. Every quarter, public companies release their earnings and the 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, if they think the actual earnings will be lower than expected, they will buy puts. 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 an 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. A striking feature of all this selling is a steep decline in the option's value
Let's use stock ABC for an example. In this scenario, ABC is trading at $100 the day before earnings. With one day left to expiration, the straddle can be bought or sold for $2.00. This means the market is expecting 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 is expecting a whole 20% move on earnings (($20/$100 = 20%).
Based on the two scenarios above, even rookie traders are quick to 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. In this case, 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 the logic behind that decision.
Well, she looked back at prices around previous earnings announcements and noticed stock ABC moves on average 2%. For this reason, she believes her straddle is valued fairly and does nothing.
Whether the earnings release brings us good, bad or even new information, this time allows us to re-value the stock. And unless the company is planning some major event in the future (i.e. putting themselves up for sale), uncertainty decreases. 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 here: When stocks make large moves down after earnings, the underlying options still experience a volatility crush. I know this seems counter intuitive 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 go up. However, this is not the case at earnings. Even a bad report still 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 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 on a weekly basis!
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 available right here on our website.