Implied volatility crush (or IV crush, for short) is a term used in options trading to describe the sudden decrease in implied volatility that can occur after a significant event, such as an earnings announcement or a major news event. When implied volatility decreases, option prices also decrease, which can have a significant impact on option traders.
Before we get into the technical definition, let’s explain it as simply as possible. If you already have a deep understanding of IV crush, or just want the technical explanation, you can skip this section.
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IV Crush Explained at a 5th Grade Level
We know, it sounds silly, but explaining high level concepts in a nuanced, fun way is something that we feel doesn’t happen enough in the finance world. So for the sake of this example, let’s imagine that instead of stocks or options, we’re talking toys.
Implied volatility is like a guess of how much a toy’s price will change in the future. It’s like guessing if the toy will become more or less expensive. When many people think the toy’s price will change a lot, they want to buy the toy option for more money, and when people think it won’t change a lot, they don’t want to pay as much for the toy option.
Now, imagine a toy that has a big event coming up, like a big show where a new exciting toy might be unveiled, and everyone thinks the toy’s price will change a lot after the show. So people start buying coupons for the toy, hoping they can buy the toy for cheap and resell it after the announcement, to make a profit.
However, after the show, the toy’s price doesn’t change as much as people thought, and suddenly, people aren’t as interested in the toy anymore! People who bought a bunch of coupons that expire right after the event hoping that the toy’s price would shoot up in value and that they could quickly make a buck got really sad! This sudden change is what we call an “implied volatility crush.”
To avoid this, people can either not buy the toy coupon that expires right after the big event (ie: make sure their coupon expires at a way later date), or people can even consider selling coupons themselves!
Now that you get where we’re coming from, let’s talk directly about IV crush, sans all of the “toy talk.”
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What is Implied Volatility Crush?
The term “implied volatility” refers to the market’s expectation of how much a stock price will move in the future, based on the price of its options. When investors believe that a stock price will move significantly, they will demand a higher price for options, which leads to higher implied volatility.
However, when an event occurs that makes it less likely for a stock to move significantly, such as a company reporting better than expected earnings, implied volatility can quickly decrease, leading to a drop in option prices.
This sudden drop in option prices is what is referred to as implied volatility crush. This can be a challenging situation for option traders, as they may find themselves losing money even if the stock price moves in the right direction, due to the decrease in implied volatility.
How to Avoid IV Crush When Trading Options
The surest way to avoid implied volatility crush: Option traders should avoid buying long options directly before earnings. However, sometimes that stipulation can become a hindrance, especially if you have a strong hunch that the move will take place on earnings.
If you must make a trade through earnings, there are a few ways to do it that allow you to exploit IV crush, rather than be exploited by IV crush.
How to Exploit IV Crush: The Opportunity in Volatility
Traders can utilize credit spreads (for example, sell out-of-the-money verticals that are already swollen in value) in order to take a volatility-negative approach to a trade! That means as volatility declines (AKA: IV crush), the position rises in value.
Traders can also use diagonal spreads in order to sell short-term, “overpriced” options while simultaneously taking a long term position in the same direction. In a diagonal spread, the short-term option reduces the price of the long term option!
Interested in taking a more aggressive approach? Consider volatility arbitration. Volatility arbitration trades through earnings ask traders to compare the average earnings move with the current implied move, searching for deviations.
For instance, if the average move is 8%, but the options market is pricing in 3%, that might be a sign that the options market is underpricing the options — it could be a good idea to go long-volatility with some long options or a long debit spread. Conversely, if the options market is pricing in a much larger move (maybe, 20%), and the average move is 8%, it could be a sign that the market is overpricing options. For something like this, you might consider a calendar spread or a short iron condor!
The Bottom Line
Implied volatility crush lives in the nightmares of many an options trader — but it doesn’t have to. Smart traders navigate IV crush with ease, and they use many of the tips we described above! Even so — IV crush can be challenging to tackle if you’re new to the world of options, so just remember:
By avoiding short-term options, traders can avoid IV crush entirely. By utilizing vega negative strategies, like credit spreads and short iron condors, traders can allow IV crush to power up their trades. And by knowing what the average move is on similar binary events, traders can know exactly how to position ahead of these potentially volatile times.
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Rebel Weekly
Every week, we deliver two options trade ideas to you, alongside step-by-step instructions about how and when to execute the trades.
What you get:
- Detailed Trade Write-Ups
- Trade Explanation Video
- Entry, Exit & Stop-Loss Triggers
- Chart Analysis & Technical Levels
- VIP Friday Virtual Cocktail Hour
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