blog

What Is IV Crush? How To Take Advantage Of It

Options Trading 101 - The Ultimate Beginners Guide To Options

Download The 12,000 Word Guide

Get It Now
As Seen On
by Gavin in Blog
July 12, 2020 4 comments
what is iv crush

IV crush is a phenomenon that tends to catch many beginners off guard.

It is a situation where the extrinsic value of an option contract declines sharply because of a significant event occurring.

For example, the reporting of corporate earnings or a regulatory announcement.

Contents

To understand what an IV crush is, we first need to cover implied volatility (IV).

What Is Implied Volatility?

Implied volatility is a metric used by traders to provide a forecast for the likely future change in a security’s price.

When we trade options, we take on two views.

One view is on the direction of the stock, the other on its implied volatility.

As implied volatility increases, it results in options having a higher premium.

This is because the price of options are valued based on intrinsic value (the value of the option if exercised today) and extrinsic value (the time value of an option).

Therefore, an increase in implied volatility means an increase in the options extrinsic value.

A decrease in implied volatility lowers the options extrinsic value.

As a company’s earnings date approaches, there is a rise in the uncertainty of the company’s future stock price.

This translates into a higher extrinsic value for the options on the company.

You can read a full guide on implied volatility here.

IV Crush

Yet once the event has occurred the options will lose the extrinsic value of that event.

This will typically occur right after an event has occurred.

We go from an environment where there is unknown information to an environment where the information is now known.

Put simply, it means the market is moving from uncertainty to certainty.

As alluded to earlier, this is something like an earnings announcement.

Market participants speculate on the results and then react once the results are released.

This can also happen with any significant event, e.g., an FPA approval date, the outcome of a legal battle, etc.

Let’s work through a conceptual example to see how this plays out.

IV Crush Example

Say that a company is due to report earnings soon, and several market participants believe that actual earnings will end up being higher than what is currently expected.

To capitalize on this forecast, the market participants buy a few calls ahead of the announcement.

At the same time, some market participants believe actual earnings will end up being lower than expected and so they buy puts.

With no consistent view of the future, a sudden surge in demand for both puts and calls is created which pushes up volatility as both sides hope to make a profit from the announcement.

Eventually earnings day arrives, and the company releases its results, which means the market now has certainty on the company’s true earnings.

As a result, traders rapidly re-evaluate their positions and decide whether to hold or close their positions.

With the market having increased certainty, volatility drops very quickly, resulting in an IV crush and a steep decline in the extrinsic value of options.

This dynamic occurs even when company earnings reports are bad, because ultimately what matters is not what the results were, but that there are now results which allow for an increased level of certainty for investors.

Below you can clearly see the effects of iv crush on GOOG after each quarterly earnings announcement.

iv crush

Protecting Yourself Against IV Crush

To protect yourself against volatility crush, there are you two key actions you can be taken.

The first is to avoid trading options where the expiration month contains an earnings announcement.

It is in the expiration month containing an earnings announcement that traders are at the highest risk of a volatility crush as stocks are re-priced because of the announcement.

The final way is to pay close attention to an option’s historical volatility, to compare whether implied volatility is relatively high compared to historic norms.

If you discover implied volatility is higher than historic norms, avoid buying options on that stock until implied volatility settles back down.

what is iv crush

Despite this it is important to note IV crush is not a free lunch for options sellers or something that must be avoided when buying options.

This is because an IV crush is accompanied by a realized move in the stock. New information comes out and the stock reacts to that information.

This is known as gamma risk and affects the intrinsic value of the option.

Imagine Facebook is trading at $120, and we sell the $130 options expiring Friday for $4.35. At the point of our trade the option has 0 intrinsic value and $4.35 in extrinsic value.

Facebook has their earnings after hours, and the stock blows out.

It opens the next day at $140. The 130 call is now trading at $10.10.

It now has $10 of intrinsic value and only 10 cents of extrinsic value.

IV crush happened but the realized move outpaced it and we lost money.

Conclusion

An implied volatility crush is when the extrinsic value of an options contract declines sharply because of a significant event occurring, such as the reporting of corporate earnings or a regulatory announcement.

It occurs due to the increasing uncertainty in the lead up to a significant event, followed by the sudden and sharp drop in uncertainty as the event occurs and the general market digests the results.

Traders can protect themselves by avoiding options with high implied volatility, avoiding options with an event occurring in the expiration month, and avoiding options that have a higher implied volatility compared to historic norms.

However, by doing so, they risk missing out on potentially lucrative short-term trades if the realized move is larger than the market expects.

As with any trading approach, ensure you exercise appropriate risk management strategies and use it as part of a well-thought-out strategic approach.

Trade safe!

Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.

vol trading made easy

4 Comments
  1. Brady says:

    Thanks for teaching me what Iv crush is found u on Google

    1. Gavin says:

      You’re welcome. Glad we could help.

      1. Anonymous says:

        Thanks Mike from Stockwits

        1. Anonymous says:

          Thanks Mike and On1

Leave a Reply

Your email address will not be published.

Options Trading 101 - The Ultimate Beginners Guide To Options

Download The 12,000 Word Guide

Get It Now