- Implied Volatility (IV) Explained
- Implied Volatility in the Options Market
- What is IV Crush?
- When Is It Possible to Stumble Across an IV Crush?
- Following a Company’s Earnings Reporting
- Is It Possible to Prevent an IV Crush?
- Illustrating an IV Crush on the Eve of Reporting
- Positive or Negative, Earnings Reports Bring Light
- IV Crush: Conclusion
The term «volatility crush» is used in the options market to define a rapid drop in implied volatility (IV crush) of an option, which is caused by reporting the underlying asset’s earnings or another big news event.
A volatility crush is likely to take novice traders by surprise when corporations report their earnings or a regulator makes an important announcement, influencing the extrinsic price of an option and leading to its plummeting. It is possible to face a losing trade because of the IV crush even if the stock price moves in favor of the trader. So, traders have to familiarize themselves with the peculiarities of an IV crush and discover how to escape it.
The first thing you need to do is to understand the essence of implied volatility. Our blog will help you to identify the trap and avoid its negative consequences.
Implied Volatility (IV) Explained
In trading, IV (Implied Volatility Crush) is a metric for forecasting possible changes in a security’s price. It helps predict price fluctuations, supply, and demand, as well as calculate a price for options contracts.
The options’ value consists of intrinsic and extrinsic value (i.e., risk premium); so, an increase of IV causes a higher premium in options.
As the date of releasing a company’s earnings report nears, the uncertainty of the future stock price grows. As a result, interest in related options contracts also heats up, resulting in their extrinsic value boost, which influences IV. However, when IV is too high, the option contract value is in danger of shrinking due to a volatility crush.
Volatility Crush Options: Implied Volatility in the Options Market
Usually, IV serves as an instrument for estimating options. Lower implied volatility lands options with reduced premiums, working exactly the other way round for higher IV.
It is commonly known that there are two factors that help evaluate an option contract: intrinsic and extrinsic value. If you are a newbie in options trading, you need to remember that the latter correlates to a “risk premium”. If you want to learn more about that, visit our page with an option course.
Next, if the perceived uncertainty of an asset’s price advances, we arrive at increased demand for option contracts in this security. The demand boosts its extrinsic value along with IV. As a rule, we can observe such a situation shortly before public companies publish their earnings reports.
Implied Volatility Crush: What is IV Crush?
Implied volatility crush (IV crush) describes the situation in trading when IV slumps, usually on the news like FDA announcing its decisions or companies reporting their earnings. Only a dramatic change in IV results in implied volatility crush.
The process of the market transition from the point where some information is unknown to the point where it is already known causes an IV crush. So, the uncertainty of the market is replaced by confidence based on the provided information.
As it has been stated, market players can trade on upcoming news prior to its publication and then respond to the outcomes announced. The news can refer to any big event affecting a company’s well-being, from a court decision to a merger approval.
It is easier to understand all details through an example. So, we have prepared one for you.
A certain company is about to demonstrate its earnings shortly. Some market players have an opinion that the profit will turn out to be larger than it is currently forecasted. They purchase a number of calls prior to the reporting to get benefit from this prediction.
Another half of the players assume the profit will be smaller than estimated, which makes them opt for puts. Therefore, there is a great demand for both calls and puts due to the lack of information, with both parties banking on earning some cash after the company’s report is published. Such activity on the market whoops up the volatility.
When the company finally shows its earnings, the market situation becomes distinct, helping everyone revalue their positions and define a plan of action. Some players choose to close their positions as soon as possible either to prevent further losses or to derive profits, depending on how lucky there are at predictions.
The volatility decline, triggered by the clarified situation, is as fast as its increase; so, it produces an IV crush. In its turn, it leads to the value of the option being reduced.
Even if the company’s earnings are low, the scenario is just the same. The point is that it does not matter whether the results are bad or good because the main thing is that there are certain results that allow investors to act for sure.
IV crush could have some negative consequences, but you can avoid them by acting in either of two possible ways.
The first method is to refrain from dealing with those options that expire within the period scheduled for some major news releases. A volatility crush lurks in wait just when companies are about to publish their earnings reports, as traders will be revaluating the underlying after the news is released.
Another method is to explore the history of the option’s volatility and compare forecasts with the historical norms. If the IV turns out to be higher than the average, do not acquire options on that stock. Wait for the IV to stabilize.
When Is It Possible to Stumble Across an IV Crush?
Usually, the timeframe when we have the highest odds to encounter this phenomenon spans from the time when the trading market is characterized by uncertainty to the time when a definite event brings certainty.
IV always increases before such an event and decreases after it. It can be frequently observed at the times when an earnings announcement is prepared. You can follow the corresponding changes and fluctuations in our live trading room.
Following a Company’s Earnings Reporting
Although a company’s earnings information is kept secret, it is possible to have a sneaky peek at it at quarter-end. All public companies demonstrate their profits on a regular basis during this time. This information is both essential and exciting for all investors. That is the reason for a swift rise of implied volatility before the announcement day and its dramatic decline in the post-announcement period.
In anticipation of the news to come, traders who assume that the real earnings will be higher than projected buy calls to hit the jackpot. Contrariwise, those players who are sure that the profit won’t be that great purchase puts. This is also the way to get benefits from the announcement.
Therefore, the increase in the number of calls and puts causes the rise of IV. And when the report is revealed, all the trades are closed lightning-fast. So, the massive sales produce slashed volatility and end in an IV crush coupled with a decreased price of the option.
Is It Possible to Prevent an IV Crush?
For the crush to do you no harm, opt for purchasing options only if the IV is low. You can also choose to sell within those anticipation days although it is a venturesome way to go. However, selling is still not a bad idea keeping in mind that 80% of options expire without being closed.
Illustrating an IV Crush on the Eve of Reporting
Say, we have ABC stock priced at $100 on the eve of reporting about the company’s earnings. Since the contract expires shortly, it is possible to buy or sell it for $2.00. So, players would bargain for a 2% move the next day ($2.00/$100 = 2%).
But we can also assume that the price for the straddle is set at $20 a day earlier the announcement. In this case, the projected move would amount to 20% ($20/$100 = 20%).
Considering the two scenarios mentioned above, it is not difficult to understand how great the gap between those expectations is.
If a trader discovers the 20% opportunity and decides to get rid of the straddle right away, they will win anyway. Even if the underlying does not reach 20% on the earnings day, the trader gets their bonuses.
However, the market participant may refrain from doing anything with the 2% occasion. If we explore previous earnings announcements of this company, we can notice that the stock’s move was more or less just like that — 2%. So, it can be assumed that the underlying is priced fairly, and there is no reason for taking any actions at all.
That’s why it is useful to refer to $CARA before the earnings day. Look at the lower part of the screen to see how IV changes around the big date. When you see a boost, it’s time to sell if you want to enjoy a nice premium when IV plummets.
Positive or Negative, Earnings Reports Bring Light
It does not matter whether an income statement speaks about the company in a positive or negative way or even adds nothing new at all — the time is just right to revise the price of the underlying. The greatest power of an earnings report is that it establishes certainty on the options market. Therefore, traders receive a possibility to evaluate the perspectives of the company, which can be affected in the nearest future only by some major event like a merger or acquisition.
In addition, it is necessary to take into account the next fact. When in the post-earnings period stocks decline sharply, the underlying options are still affected by the IV crush. It may seem strange since a greater panic is supposed to reduce volatility, not vice versa. There is an example to explain the logic behind this fact. Let’s consider the S&P 500. When the index drops, the Volatility Index is projected to rise. But when it comes to earnings, even degenerating financial metrics provide us with an insightful view of the company. It allows for re-pricing the stock, making the situation much clearer and decreasing IV. An expiration month offers a great opportunity to chase volatility to trade with our stock alerts posted several times a week.
IV Crush: In Wrapping Up
An implied volatility crush is used in trading to predict an increase and decrease of the options price. It helps traders to avail of the changes and receive some benefits.
The term describes a steep downfall of the extrinsic value of an option, which is caused by an event shedding light on the company’s financial standing and operations. Such a decline of implied volatility happens because certainty comes back to the market after a period of vagueness on the eve of the event.
It is important to understand that an IV crush can leave traders with losses even if the stock price moves in their favor. Fortunately, you can save yourself by steering clear of options with high implied volatility or those with volatility higher than the average based on its history. Options that expire shortly after a big event is scheduled should be also avoided.
However, do not miss on gainful short-term trades, which can be closed successfully with risk management and strategic thinking at hand. In addition, like in any trading, it would be reasonable to explore the market and its history to elaborate a strategy.
Read also: What is the TaaS Stocks.
Traders can make more beneficial decisions if they consider the scenario with increasing premiums in the run-up to an earnings announcement coupled with a probable IV shrinkage afterward. Being familiar with an IV crush is necessary for successful options trading, as well as understanding the dynamic nature of volatility, with different changing components attached to it. If you use it properly, it helps you to earn big.