How to Take Advantage of an IV Crush
Implied volatility is the expected volatility of an underlying asset over time. It is one of the key data points for pricing options and it will be a big factor in deciding the profitability of your options trades.
One of the most important factors to look out for is known as “IV Crush”. IV crush is a situation where the extrinsic value of an option contract drops sharply due to a significant event occurring in the market, such as corporate earnings or a regulatory announcement.
Options prices are valued based on their intrinsic value (the value today) and extrinsic value (the time value of an option). An increase in implied volatility will mean an increase in the options extrinsic value. A decrease in the implied volatility lowers the extrinsic value.
In my thirty years of trading options, I have witnessed many surprise events that led to an IV crush and learned how to prepare for such events.
What is IV Crush?
The IV crush is a term used by options traders to describe a scenario in which Implied Volatility decreases very quickly in the underlying asset. This usually occurs after an important event, such as earnings, or a regulatory announcement.
How to Avoid IV Crush
IV crush is a phenomenon that occurs with surprise announcements, or scheduled releases. We track these sorts of events in our Live Interactive Trading Room and this will ensure you are prepared for any upcoming announcements on a stock.
IV Crush Following Company Earnings
Company information is a closely guarded secret but the quarterly earnings releases are an opportunity for the market to get an update on the company’s performance. This can bring good news in the form of stronger revenues or net profit, but it can also bring negative surprises in the form of fines, losses, or adverse changes in investments.
Implied volatility in options will increase ahead of the earnings announcement due to the unknown element and can decrease rapidly following the release.
For example, investors hoping for an earnings beat might buy call options and this will increase the implied volatility. If the release showed a lower-than-expected financial performance, the call options will lose a large portion of their extrinsic value. This occurs because traders now see less potential for that particular option to reach the strike price in the time to expiry.
How to Profit from IV Crush
Profiting from IV crush is dependent on buying options when the implied volatility is low. This can be slightly ahead of an announcement as many will track company earnings a week in advance.
Traders should pay close attention to the option’s historical volatility, and compare IV against its historical valuations.
The other way to profit is to sell call options just before the announcement. This can be a risky strategy, but the majority of options expire worthlessly and some research on the company earnings trends could improve the chance of a reward.
Sellers Beware of Gamma Risk
Selling call options is not a simple strategy if the stock sees a large move after earnings. This is known as gamma risk and also affects the intrinsic value.
For example, if Netflix is trading at $240, and we sell the $250 options expiring Friday for $4.35, the option has 0 intrinsic value and $4.35 in extrinsic value.
If the company beats on earnings and the stock opens at $260, $240 call is now trading at $10.20. It now has $10 of intrinsic value but only 20 cents of extrinsic value.
The IV occurred but the move in the stock meant that we lost money in the trade.
The IV Crush is a very important part of stock options trading, especially in earnings season. Earnings volatility is a dynamic event and can offer savvy traders a chance to profit if they are well prepared.
The key when buying call or put options is to do so when the implied volatility is low. That will limit your downside and avoid the dreaded IV crush.
Once you master this phenomenon, a quarterly earnings season will have many opportunities for profit. For more on options Gamma and Theta, check out my previous article on weekend valuations.
See my previous Article Here on Do Options Lose Value Over the Weekend