Implied volatility (IV) is a key metric used to gauge market sentiment concerning the likelihood of a given asset’s price change. IV is especially important for traders who need to price options contracts because IV is essentially an estimation of a security’s real-time price value as it’s being traded.
When investors buy or sell options contracts, they have to take on two considerations: one is whether the stock will go up or down and the other is its implied volatility. If IV increases, an option can demand a higher premium, as greater implied volatility suggests the underlying stock may move more over a given period.
As will be discussed in this article, the value of an option can fall due to a loss of implied volatility. This phenomenon is known as an IV crush and is a critical component for all kinds of options trading.
What Is an IV Crush?
An IV crush occurs when the uncertainty surrounding an underlying option’s security dissolves. The drop in volatility can cause the extrinsic value – or the time value – of an options contract to fall, making the contract worth less to its holder.
The quick decrease in IV happens because new information is available to traders on which to price the option.
Events such as quarterly earnings reports and company news announcements can severely affect the level of implied volatility.
How Does Implied Volatility Crush Affect Options Prices?
Pricing an option is a complicated endeavor, involving many different factors such as the current value of an asset, the strike price and expiration date of the option and the predicted volatility of its price as a function of time.
The more an option’s strike price differs as to its present price, the more the option will be worth. This is because the greater the difference between the two metrics, the more volatility in the contract is implied. Ultimately, implied volatility is a measurement of how much the market expects the price of a security to move up until the option expires.
All other things being equal, the price of an option should correlate with its implied volatility i.e. If IV rises, the option’s premium becomes more expensive; if the IV falls, the premium becomes cheaper.
The implication of this is that when an IV crush takes place, anyone holding an options contract losses out. The market has moved from a state of uncertainty – higher volatility – to one which is more certain, thus less volatile.
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IV Crush: Some Real-World Examples
The general principle informing the reason behind an IV crush is, as mentioned earlier, a rapid drop in the uncertainty of a stock or other asset’s future price movement.
This scenario often plays out when a company publishes its quarterly earnings report. Take, for instance, what happens in the run-up to the day that earnings are released.
Some traders – who are bullish on a given company’s prospects of meeting the market’s expectations – may seek to capitalize on their assumptions by purchasing some call options to leverage their returns from the position.
On the other hand, some other traders, who happen to be bearish on the stock and believe it will disappoint on its earnings call, might do the opposite, buying some put options instead.
The result of these two actions – that is, the frantic buying of both put and call options by traders in the market – is an increase in volatility.
However, when earnings day does come around, the market receives further important information on the state of the stock and uncertainty and volatility both drop. It doesn’t matter in this case whether the company met its profitability targets or not – the simple fact is that the unknown quantity going into the event is now known. Traders can now re-evaluate their position and either hold or exercise their options.
This drop in volatility is precisely what defines an IV crush.
To accent the point further, let’s take a hypothetical situation using some concrete numbers. In this case, we’ll assume two examples for Company X as follows:
- Example 1: Company X is trading at $100 the day before earnings and the straddle price is $3, implying that the market expects the stock to move three percent come the earnings report.
- Example 2: Company X is trading at $100 the day before earnings, but this time the straddle price is $15, implying the market believes the stock will move 15 percent after earnings.
Although the difference between these two scenarios appears stark – a three-percent post-earnings shift against a 15 percent shift – the only important thing for a trader to consider is whether they think the straddle option is fairly priced.
This means that so long as the market moves as expected, their position should be a winner if they sell the option before an IV crush-inducing event.
Once the crush takes place, that option is worth less to the holder. The counter-point to this would be if earnings were spectacularly bad or some other news item broke that increased, rather than decreased, uncertainty around the stock.
How Do You Avoid An IV Crush?
The best way to protect yourself against an IV crush is to stay away from trading options contracts at the time of known events that could trigger a collapse in an underlying asset’s volatility.
The most obvious example of this would be a company’s earnings release – but there are many other occasions to be wary of too. For instance, some industries face highly seasonal risk factors that can adversely their fortunes, resulting in some unfavorable news items that can stoke up volatility and uncertainty.
Other events include major product launches which have the potential to fall flat or regulatory decisions that can limit a firm’s ability to do business. Political hand-overs, such as general elections or leadership resignations, are also predictable occasions that can affect the market in various ways.
Another factor to consider is historical volatility and whether the implied volatility at a given time is in keeping with its previous norms. If it turns out that IV is higher than expected, it would be wise to hold off on making any options trades until the volatility settles down. An exception might be a covered call, where a stockholder takes advantage of abnormally high implied volatility to sell call options that lower their effective cost basis.
Investors should also be careful of thinking that an IV crush is only a threat to options buyers or that it’s an easy money-making opportunity for sellers too. Traders must recognize that a market can realize the expected move, while also exceeding it too. When this happens, the intrinsic value of an option can change, not just its extrinsic value.
An example of this would be if a stock was trading at $100 and the $110 call option was sold for $5. At the time of the trade, the option would have an intrinsic value of $0 and an extrinsic value of $5.
However, if after a particularly good earnings beat, the company were to see its shares break out to $120, and the $110 call swapped hands for $11, there would now be $10 of intrinsic value and extrinsic value of just $1.
In this case, the IV crush took place and the predicted move was realized – but the actual magnitude of the shift exceeded the market’s prior expectations, leaving the seller in this scenario losing money.
How Does Earnings Affect An IV Crush?
There’s a kind of inherent paradox within the concept of the IV crush that can upend investors if they are not careful. And the paradox or logical trap is this: implied volatility can be crushed whether the price action of a stock goes up or down.
This, at first sight, might appear irrational: most traders recognize that when stocks fall in price, volatility increases; and when stocks rise, volatility decreases. This is Investing 101 stuff.
It might then be reasonable to conclude that a bad earnings report, as opposed to a good one, would increase volatility and possibly mitigate the likelihood of an IV crush. But it’s not so – and it’s because of this one, crucial point: poor results still provide actionable information to the market, information which investors can use to re-price a stock. And when the market becomes more efficient, uncertainty drops – and with it volatility too.
So, while many other financial considerations need to determine whether earnings are good or bad, it’s not so important when it comes to whether an IV crush occurs; what is important is simply that the market can reprice a security and reduce volatility. Unless, of course, the price movement of an asset overreacts to what was expected, as in the options example in the last section.
IV Crush And LEAP Options
One special case of an options contract, the LEAP—or Long-Term Equity Anticipation Securities—allows investors to trade options with an expiry date longer than the standard year.
The benefit of this concerning an IV crush is that there is a longer period over which a holder can sell the contract since there can be many years before the option expires.
LEAPs do not differ substantially from other short-term options but do offer greater exposure to more prolonged and larger price movements. Traders should note, however, that the IV crush is still a potential threat, especially as the expiration looms closer.
IV Crush: Conclusion
The likelihood of an IV crush increases as the horizon of a significant pricing event approaches. The crush essentially refers to a sharp and rapid loss of the extrinsic value of an option.
Investors can mitigate the harm caused by an IV crush by not trading options that have expiration dates close to events that may reduce implied volatility or by keeping tabs on whether current volatility is in line with what had occurred historically.
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