With the new year approaching, many traders are reassessing their strategies and preparing for market conditions ahead. While implied volatility (IV) is a well-known component of options pricing, understanding how IV behaves -- and how quickly it can decline -- is just as critical to long-term success.
This article explores the concepts of IV crush in options trading. We'll begin by defining implied volatility and its importance in options trading. Then, we will discuss what IV crush is and the factors that can cause it.
How Implied Volatility Works
Implied volatility represents the market's prediction of volatility level for a particular stock or index. IV is crucial to understand as an options trader since it significantly affects option pricing.
High implied volatility signals traders of a large stock move afoot, which leads to options being more expensive since people are expecting a significant move and now purchasing more options contracts.
On the other hand, when implied volatility is low, options are much cheaper since people don’t feel the need to actively hedge a large move.
Options with a higher IV are more expensive because they have a greater chance of ending up in the money, and vice versa. As a result, traders must be aware of the current IV levels to assess the fair value of an options contract and determine if it's overvalued or undervalued.
What is an IV Crush in Options Trading?
Implied volatility crush occurs in the options market when the a stock's IV rapidly decreases which can happen for various reasons, such as varying market conditions or stock-specific news. IV crush often occurs after a major event, such as an earnings report or a news announcement that caused elevated IV.
The extrinsic value of an option is hyper-dependent on IV, so when an IV crush occurs, the extrinsic value drops significantly. This sudden drop indicates that traders no longer expect a significant move causing option prices to decrease.
Earnings reports are one of the most significant events that can lead to an IV crush, as they tend to bring uncertainty, and investors tend to anticipate a larger than normal move in the stock's price.
Understanding Implied Moves
The implied move is how much an underlying stock is expected to move over a period of time. This element is often applied in options trading to help traders make informed decisions about which options contracts to buy or sell.
You can calculate a stock's implied move by determining the price of an at-the-money (ATM) straddle. If you want to find the implied move of an earnings or news event, you should build the straddle on the expiration date right after the event.
For example, if a stock is trading at $100, you would buy the $100 call and put to build a straddle. Say the total cost of the strangle is $10, this means the expected move of a stock for that expiration cycle is $10.
As long as the underlying stock stays within the implied move, option sellers will win, and option buyers will lose. If you believe a stock will not move outside of its implied range, you would sell options. Although, if you believe that the IV is understated and the stock will move outside of its implied range, you should be a buyer of options.
It's important to note that calculating the implied move is not an exact science, and is not a guarantee of how the stock will move. However, it can provide a good estimate of the potential price movement, which can help traders decide whether they should buy or sell premium.
IV Crush Post-Earnings
When a company releases its earnings report, the market will react, causing the stock to sell off or get bought up, depending on whether the earnings were better or worse than expectations. This can cause the stock price to fluctuate significantly, affecting the implied volatility of options contracts on that stock.
Before an earnings announcement, traders generally buy more options than usual, causing IV to increase. When a stock releases earnings, several investors may change their minds about the stock depending on how the earnings look, which causes more uncertainty than usual.
After earnings are released, implied volatility tends to drop quickly, signaling an IV crush, as the unknown becomes known, and the stock price reacts to the information.
How to Profit From the IV Crush
The most common way to profit from IV crush is to sell options before a company reports earnings. If a trader believes implied volatility is overstated, they can profit by utilizing short volatility strategies like the iron condor or short strangle.
To implement this strategy, you would find a stock reporting earnings in the near future and sell a strangle or an iron condor on the expiration date following the earnings report. Now, you might be asking what is an iron condor or a short strangle.
The iron condor involves selling an on-the-money (OTM) call and put, then buying even further OTM calls and puts to make it a defined risk trade. An iron condor benefits from IV crush if the stock stays within the implied move, allowing you to generate a quick profit.
However, if the underlying stock moves further than its expected move, the iron condor will lose money and inflict profit loss. Having a plan for when trades become losers is crucial to managing your risk.
The short strangle is similar to the iron condor, as it involves selling OTM calls and puts. However, the short strangle doesn’t include buying any options, making it an undefined risk trade.
The short strangle allows you to collect more premium but is significantly riskier as the risk is undefined. Therefore, if the underlying stock moves substantially further than its expected move, you can take a significant loss.
While each strategy offers opportunities for traders to profit from IV Crush, they also come with risks that traders should be aware of.