What Is Implied Volatility Crush?

Do you know what IV crush is? An option is said to be volatility crushed if its implied volatility is swiftly reduced after earnings or other significant news is announced about the underlying stock.

When there is a volatility crush, the implied volatility of options rises as the stock's price path is most uncertain before an earnings announcement and falls after the announcement.

The IV Crush is one of the most important aspects of stock options trading in earnings season. The volatility of earnings is a dynamic event that can be a source of profit for traders who are well prepared. 

Calls and puts are best acquired when implied volatility is low. You will avoid the dreaded IV crush when implied volatility is low. 

Having mastered this phenomenon, you will profit in a quarterly earnings season. First, let's dive into the discussion of implied volatility and how it works. 

Implied Volatility Indicators and Signals

Implied volatility - what is it?

Option pricing involves strike prices, expiry dates, stock prices, and price volatility over time. Comparing strike price to current price (or asking price) and finding a more significant difference will result in more expensive options. 

You create implied volatility for options traders by combining rapid changes in market demand with rapid changes in implied volatility.

To understand the pricing of any stock or option, implied volatility is vital. The difference between profiting during a volatility crush and losing your money lies in understanding the demand curve, especially leading up to earnings and big announcements.

Option prices are determined by the difference between the strike price of an option and the underlying stock's current price. The more significant that difference, the greater the premium, representing the uncertainty of that stock's volatility!

As a result, a premium implies expected volatility for an option.

What is implied volatility crush?

Let's talk about what is implied volatility crush! The value of an option will be crushed by a fast and sharp drop in implied volatility. 

An event like a financial report, regulatory decision, new product launch, or quarterly earnings announcement often causes the stock to plunge.

The implied volatility crush strategy combines puts and calls to profit from decreased implied volatility. 

A stock's implied volatility in the middle weeks before an earnings announcement is often based on a stock's earnings announcement and, more specifically, in the middle weeks ahead of earnings.

In these instances, market makers price substantial price into options (via implied volatility). Because of this, it is important to recognise implied volatility levels before entering a trade.

The price of stock options will be higher if volatility is higher before a significant event. As a result of the event, the stock price did not rise as much as the analysts had expected or even decreased. 

The premium on the option is reduced regardless of whether the stock price rises due to uncertainty about price point resistance and other factors. Because of this, even if the stock is rising, the option price drops.

When the implied volatility and stock movements diverge, the options market deteriorates, and you, the trader, lose money even if the stock is rising.

An example of this would be during a significant decline in the Market Volatility Index (VIX), which would indicate macro-level developments in the market overall. 

VIX's steep drop signals traders that implied volatility is higher than historical volatility, and the consequent volatility crush will either wipe out your profits or make you look bad, not to mention ruining your entry.

Examples of IV crush

To help you understand volatility in the market, here are two examples:

1. The day before earnings, the stock price of Apple is $100, and the straddle price is $2 one day before expiration (market expectations for a 2% move on earnings day or $2.00/$100 = 2%).

2. One day before earnings, you have TSLA's share price of $100, with a straddle price of $15 (market expectations of 15% move on earnings or $15/$100 = 20%).

In these two examples, a veteran can immediately see the difference in expected earnings between the two companies. The trade would be a winner if the stock never moved below 15% on earnings day based on the 15% scenario and selling the straddle pre-earnings. Why does this matter to options traders?

For example, a trader who knows the significance of a 2% move on historical AAPL earnings reports may decide to hold the position as a "fairly" valued investment. 

Understanding options trading is fundamental to understanding the historical perspective of volatility. This is where you will find the real opportunity to earn money. 

In most cases, earnings are an excellent opportunity to find a winning trade, except when there is bad news, such as the failure of a technology or a company's liquidation. 

Furthermore, in situations where stocks are crashing, options will experience a volatility crush. You can imagine this scenario easily, even though it seems evident and related to fear. SPY is falling, and VIX is rising.

Implied volatility: what causes it to rise or fall? 

Stability decreases implied volatility, and uncertainty increases it.

VI represents future volatility and is forward-looking. The price of options rises when IV rises as the price range of the underlying security expands. Therefore, the range of possible outcomes is more comprehensive when volatility is higher.

Before potentially volatile market events, implied volatility tends to expand.

An earnings announcement, economic data release, Federal Reserve announcement, and other events contribute to greater volatility. As soon as the uncertainty is removed, implied volatility decreases ("IV crush").

Implied Volatility: Rise and Fall During Trading

Relationship between implied volatility and options

One of the decisive factors in the pricing of options is implied volatility. Options are contracts that allow the holder to purchase or sell an asset at a specified price during a specified period. 

The implied volatility is used to approximate the future value of the option, and its current value is also considered. High implied volatility will result in a higher premium; the reverse is true.

Probability determines implied volatility. It's only an estimate rather than a prediction of where prices will go in the future. Even though investors consider implied volatility when making an investment decision, this dependence will inevitably impact prices.

Option prices do not follow a predictable pattern. On the other hand, the Market Opinion affects the implied volatility of the option, which ultimately affects the cost of the option when contemplating an investment.

Factors that affect implied volatility

Implied volatility can change at any time, just like the market as a whole! Several factors determine implied volatility, including supply and demand. For example, the price of an asset tends to rise when it is in high demand. 

Due to the perilous nature of the option, the implied volatility contributes to the higher premium.

It is also true in the opposite direction. Lack of market demand and plenty of supply leads to lower implied volatility, which results in cheaper option prices!

In addition to the time value, the length until the option expires also influences the premium. An option with a short expiration date leads to low implied volatility, whereas an extended expiration date has high implied volatility. 

The difference lies in how much time is left before the contract expires. Due to the prolonged time, the price has a more extended period to move into the desired price level.

How can I avoid an IV crush?

The best way to avoid exposure to IV crush and the pressure that comes with it is to prevent it altogether.

Options should be traded when implied volatility is low after earnings reports - for example, right after earnings reports are released - and when the more significant market volatility (VIX) is also low. 

Even then, risk cannot be entirely avoided. You may need to hedge your position with additional options contracts if you want to ensure your losses won't surpass the amount you are prepared to lose.

How can IV crush be profitable?

Profiting from implied volatility relies heavily on the fact that it is based on emotion at its core.

It has earned the nickname "fear index" (VIX) for the same reasons. A wide variety of factors influence emotions, and those changes can occur within hours.

Compare the implied volatility of short-term and longer-term options when selecting your strategy. You will have a better insight into future market movement by doing so.

How do you value the IV Crush?

Friday's decline was not entirely caused by the IV Crush. As shown in the scenario without earnings, there would have been some Theta Decay.

From Thursday to Friday, the option premium declined by $1.80. It was down to $0.20 from $2.00 on Thursday on Friday. 

IV dropped from 43% to 25%. This is called the IV Crush.

Taking the Theta out of the "normal" period without earnings will give you the IV Crush in dollars. For example, a normal expiration between Thursday and Friday results in a Theta decay of $0.65. Since the decline was $1.80, less the Theta decay of $0.65, the IV Crush is $1.15.

Value IV Crush: Indicators and Signals

How does IV crush affect options strategies?

It's not for the faint hearts to profit from the Implied Volatility Crush strategy. To succeed in it, you need to do a lot of research, pay attention to timing, and have a high tolerance for risk.

Day traders use this strategy to manage their portfolios, which requires much attention. 

The strategy is as follows: 

• Most investors pick a company whose stock price doesn't usually fluctuate much after quarterly earnings announcements - about 4 percent or less. 

• They sell options when option prices are at their peaks before quarterly earnings. As a result, the premium they collect is substantial. 

• We buy back the options positions just after the earnings announcement. After the announcement, implied volatility has fallen, making the options far less expensive. 

Risk reduction motivates us to select companies whose stock prices don't experience large fluctuations post-earnings announcements.

When a stock price changes significantly, the value of the options contracts increases or decreases significantly; in cases where the value of the options contracts goes up, investors can enjoy huge profits - but in cases where the value goes down, investors can suffer massive losses. 

If a seller wants to manage contracts with a company experiencing higher price fluctuations, they can limit their investment risk by holding complementary strike prices and expiration dates.

Overviews on demanding volatility crush trading strategies

The IV crush occurs when implied volatility suddenly drops.

Among the most common trading strategies for IV, crush is selling option premiums. Short-selling an option involves selling the option to another party for a high premium. Nonetheless, it is also one of the least understood options strategies.

Puts and calls can be purchased in the same manner. However, selling naked options involves unlimited risk for the option seller. Buyers of US options limit their risk by multiplying the number of options by 100 times the option premium. Hence, you may lose money holding a naked call or naked put overnight than you are playing at the casino.

The metaphor is similar to asking the owners of a private backyard casino if you can earn credit for having the best poker hand you have ever had. 

Even if the math were done correctly, the other player would win the pot, and you would lose the money you brought to the table, plus you would still owe someone else a huge amount.

The first essential step in IV crush trading strategies is to educate yourself by learning from reliable free resources or taking best option trading classes; the second is to practice under any circumstances with a trading simulator or paper trading account first.

Preventing IV crush

Two key actions can be taken to protect yourself from volatility crush. First, avoid trading options with a corresponding earnings announcement in the expiration month.

Due to the earnings announcement, traders are most likely to suffer volatility crushes in the month containing an earnings announcement since stocks are re-priced.

Comparing an option's implied volatility to historical norms is the final method of determining a method's effectiveness.

Buy options on the stock until implied volatility returns to historic norms if implied volatility is higher than historical norms.

Even so, sellers of options should be aware that IV crush is not a free lunch or something to avoid when buying options.

The stock moves when an IV crash occurs. This is because it reacts to new information. In this case, the option's intrinsic value is affected by gamma risk.

Pros & cons of using implied volatility

Quantifying market sentiment is made easier with implied volatility. It predicts the size of a potential move in an asset. Nonetheless, the direction of movement is not indicated. Options writers price options using calculations, including implied volatility. 

Investors also take into account implied volatility when selecting investments. When markets are volatile, investors may opt to invest in safer sectors.

When calculating implied volatility, market assets are not based on fundamentals but solely on price. Moreover, negative news or events such as natural disasters or wars may also affect implied volatility.

Pros

1. Market sentiment and uncertainty are quantified

2. Sets options prices

3. Develops trading strategies

Cons

1. Not based on fundamentals, but only on prices

2. Sensitive to unexpected events, news

3. Movement is predicted, but not the direction

Related questions: FAQs

Why do IVs crush?

An implied volatility crush happens when the implied volatility of options rises before an earnings announcement when future stock prices are most uncertain and then falls once the earnings are announced.

What is the better way to stop an IV crush?

A crush in IVs can still be avoided by traders, however. To protect themselves, traders may steer clear of options with high implied volatility, options with occurrences in the expiration month, and options with the higher implied volatility than the course of the historical norm.

When does an IV crash occur?

The mysterious cloud covering earnings days is a big reason why implied volatility in options tends to spike before earnings day (particularly in the expiration month that captures earnings day) and decline significantly shortly after that.

Is IV higher after earnings?

In the month(s) leading up to earnings releases, we see a significant increase in IV. Once earnings are released, the uncertainty decreases, and implied volatility increases.

Final thoughts 

Traders can take advantage of volatility crushes in options markets when there is a pattern of predictable price movements. 

You can make better decisions, take better positions, and accomplish more for your overall account when you understand why premium rates rise during an important event (like earnings).

Traders need to keep implied volatility (IV) in mind because pricing is directly influenced by IV. As a result, volatility crushes have become increasingly viable options trading strategies as IV spreads have widened significantly. 

I have observed increased implied volatility before earnings announcements, resulting from option writers wishing to ensure that their portfolios are adequately protected against market fluctuations.