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What Is IV Crush?

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by Gavin in Blog
July 12, 2020 0 comments

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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 as a result of a significant event occurring, such as the reporting of corporate earnings or a regulatory announcement.

In an IV crush, even though the price of a stock moves in a trader’s favor, they can still potentially face a losing trade.

As a result it is important for traders to be intimately familiar with what an IV crush is and how to avoid it.

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.

It is used for forecasting price moves, supply and demand as well as for pricing options contracts.

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

This is due to the fact that the price of options are valued based on intrinsic and extrinsic value (i.e. the risk premium).

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 rise in demand for related options contracts, which causes their extrinsic value to rise, which then leads to an increase in implied volatility.

When implied volatility rises very high, it sets up the option contract for being at risk of an implied volatility crush. You can read a full guide on implied volatility here.

Implied Volatility Crush

An implied volatility crush occurs when implied volatility decreases very rapidly.

This will typically occur right after an event has been occurred, as it is caused by the market going from an environment where there is unknown information to an environment where the information is now known.

Put simply, it means the market has moved from uncertainty to certainty.

As alluded to earlier, this can be something like an earnings announcement, where market participants speculate on the results and then react once the results are released.

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

We’ll work through a conceptual example to see how this plays out.

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

In order to capitalize on this forecast, the market participants buy a number of 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.

Many traders will be hoping to lock in profits or stem further losses (depending on their original stance) so they’ll rapidly close their position.

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

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

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 will be re-priced as a result 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.

Conclusion

An implied volatility crush is when the extrinsic value of an options contract declines sharply as a result 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 results are digested by the general market.

An IV crush is dangerous as the nature of them means that even though the price of a stock may move in a trader’s favor, they can still lose their original investment.

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.

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!
Gav.

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.

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