How Do You Stop IV Crush in Day Trading? - Financhill

How Do You Stop IV Crush in Day Trading?

How Do You Stop IV Crush in Day Trading? Investment strategies are like vacation planning. Some people want the adrenaline rush of a white water rafting adventure, while others prefer the relaxing predictability of a five-star beach resort.

Some investors are fully prepared for significant risk in their trades, while others want reliable assets that deliver consistent returns year after year.

One of the ways investors determine whether a particular security falls into the adventure category versus the beach vacation category is through volatility. 

Historical volatility (HV), which may also be referred to as statistical volatility or realized volatility, is a calculation of how dramatically the prices of a specific security have fluctuated in a given period.

For example, stocks with high historical volatility have seen sudden price jumps and unexpected drops, while those with low historical volatility moved at a steady rate.

The problem with using historical volatility to choose current trades is that past performance does not guarantee future results. Investors want to know what to expect from assets going forward. 

While there is no foolproof method for accurately predicting what individual stocks and the market as a whole will do in the future, there are a number of data points that make predictions more accurate. Implied volatility is one such metric. 

What is Implied Volatility?

Implied Volatility (IV) compiles and analyzes data on investor behavior to capture what the market expects from a given security in coming weeks and months. The figure is an indication of the extent to which investors are expecting prices of an asset to fluctuate, so it is a helpful tool in assessing supply and demand in coming weeks. 

Investors who trade options rely on implied volatility to price options contracts. When the underlying security has high implied volatility, the contract commands a higher premium. Conversely, when implied volatility is low, options contracts are less pricey. 

What is Considered High Implied Volatility in Options?

Implied volatility is relative, so what might be considered highly volatile for one company’s stock could be average for another. The best way to determine high implied volatility for a given security is to compare historical volatility to implied volatility. 

For example, if over the past five years, the implied volatility of a given security has had a low of 10 and a high of 20, then today’s implied volatility of 17 is high as compared to its own history.

Such an increase in implied volatility is expected in the month leading up to earnings reports and other anticipated events, then it typically moves back down once the events have been factored into share prices. 

You can compare a security’s relative implied volatility by comparing it to the implied volatility of the market as a whole. The Chicago Board Options Exchange’s (CBOE) Volatility Index (VIX) uses price inputs from S&P 500 index options to illustrate market expectations for the next 30 days. For example, at the start of 2020, the VIX was between 13 and 14. When the market crashed in mid-March, that figure went over 66. 

What is Implied Volatility Crush?

By its very nature, implied volatility can change abruptly. Implied volatility is a prediction of supply and demand in a given period, and changes in circumstances lead to changes in these predictions. This is particularly likely when there is news that impacts supply and demand for a company’s stock.

Examples of events that impact implied volatility include launch of a new product, a regulatory change, and earnings announcements. A sudden drop in implied volatility – and the corresponding drop in value for options contracts – is a phenomenon  known as implied volatility crush or just volatility crush. 

In other words, traders can command a more impressive  premium on options contracts for securities with high implied volatility, because those they are trading with will pay more to secure the potential rewards. They are gambling on market expectations for changes in the pricing of the underlying securities. 

Once events pass and the underlying securities reflect those events, dramatic price swings are less likely. Implied volatility drops, and investors aren’t willing to pay higher premiums when the future is more predictable.

The sudden drop is referred to as Implied Volatility Crush, and it can be bad news for investors holding high-premium options. The options buyers are left with contracts that are worth far less than they paid. If the underlying security hasn’t changed significantly, it’s possible to lose money. 

How Does Earnings Affect Implied Volatility?

As mentioned, in the month before earnings reports are due to be released, implied volatility increases. Investors expect that the earnings reports will cause a change in the price of the underlying company stock, either positive or negative.

Once earnings reports are released, the market tends to respond quickly – often on the same day. The stock price moves to reflect the new information, and implied volatility usually returns to normal levels.

This phenomenon is particularly interesting for options traders, because it is a predictable pattern in an otherwise unpredictable marketplace. When you know implied volatility is due for a sudden drop after earnings are announced, it is possible to profit from that information. 

What Options Strategies Profit from IV Crush?

Profiting from the Implied Volatility Crush strategy isn’t for the faint of heart. It requires a lot of research, careful attention to the timing of trades, and high risk tolerance.

Typically, this strategy is limited to day traders who put all of their attention into managing their portfolios. 

The strategy works like this: 

  • Investors select a company that doesn’t usually have big changes in stock price after quarterly earnings announcements – roughly 4 percent or less. 
  • They sell options just before the earnings announcement when implied volatility is highest. That gives them the opportunity to collect substantial premiums. 
  • Just after the earnings announcement, the options positions are closed out by buying the option back. The options are far less costly, as implied volatility has dropped post-announcement. 

The reasoning behind selecting companies that don’t experience dramatic fluctuations in stock pricing post-earnings-announcement is risk reduction.

A significant change in stock price means major increases or decreases in the value of the options contracts. When the value goes up, investors enjoy big profits – but when the value of the options contracts goes down, it can mean massive losses. 

Options sellers who want to handle contracts for companies that experience larger price fluctuations can protect their investment by holding other options with complementary strike prices and/or expiration dates to limit risk. 

How Do You Stop IV Crush in Day Trading?

If you aren’t interested in the sort of pressure that comes with trying to profit on IV crush, the best choice is to avoid exposure to IV crush in the first place.

Trade options when the implied volatility is low – for example, just after an earnings report release – and the larger market volatility (VIX) is also on the lower side. 

Of course, even when you do this, you can’t avoid risk entirely. If you want to be sure your losses won’t exceed the amount you are prepared to lose, it may be necessary to hedge your position with additional options contracts. 

How To Recover from IV Crush?

The main thing to remember when attempting to profit from implied volatility is that at its foundation, implied volatility is based on emotion.

The same goes for the volatility index (VIX), which has earned it the nickname “fear index”. The problem is that emotions change based on a wide variety of factors, and those changes can occur in a matter of hours.

As you consider your strategy, try comparing the implied volatility of short-term options and the implied volatility of longer-term options. This may offer a more accurate picture of the market’s future. 

IV Crush: The Bottom Line

When it comes to IV crush, the bottom line is this: IV crush presents a real risk for those trading options. A sudden drop in the market coupled with a drop in implied volatility can put you in a position that leads to major losses.

Some of the more sophisticated investors attempt to harness the opportunities presented by IV crush through carefully calculated and timed options trading.

This is a high-risk strategy that can lead to profits, but it should be left for those with plenty of market experience. 

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.

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