IV crush or implied volatility crush, refers to the rapid decline in implied volatility within options trading following a notable event like an earnings report or major news release. As implied volatility drops, so do option prices, creating a substantial effect on options trader’s Profit and loss account.
Before delving into the detailed technical definition, let’s break it down in straightforward terms. If you’re already familiar with IV crush or seek a more technical explanation
IV Crush Simplified:
Explaining complex financial concepts in a lively and relatable way is often overlooked in the world of finance. To simplify, let’s think of implied volatility in terms of toys.
Implied volatility is akin to predicting how much a toy’s price might change in the future—whether it will become pricier or cheaper. When many people anticipate a significant price shift in a toy, they’re willing to pay more for its ‘toy option.’ Conversely, if they foresee minimal change, they won’t be willing to pay as much.
Imagine a toy with an upcoming major event, like the launch of an exciting new toy at a big show. People expect the toy’s price to swing drastically after the show, so they start buying coupons for the toy. They plan to purchase the toy at a low price and then sell it for profit after the announcement.
However, after the show, the toy’s price doesn’t change as drastically as anticipated. Suddenly, interest in the toy diminishes! Those who bought many short-term expiry coupons hoping for a quick price spike feel disappointed. This sudden drop in interest and value is what we refer to as an ‘implied volatility crush.
Implied Volatility Crush:
The term ‘implied volatility’ refers to the market’s expectation of how much a stock price will move in the future, based on the price of its options. When investors believe that a stock price will move significantly, they will demand a higher price for options, leading to higher implied volatility.
However, when an event occurs that makes it less likely for a stock to move significantly, such as a company reporting better-than-expected earnings, implied volatility can quickly decrease, leading to a drop in option prices.
This sudden drop in option prices is what is referred to as an implied volatility crush. This situation can be challenging for option traders, as they may find themselves losing money even if the stock price moves in the right direction, due to the decrease in implied volatility.
How to Avoid IV Crush:
The most reliable method to avoid implied volatility crush is for option traders to avoid purchasing long options just before earnings. However, this condition can occasionally pose a hindrance, especially when there’s a strong belief that a significant market move will occur during the earnings period.
If trading during earnings becomes necessary, there are several approaches available that enable traders to capitalize on IV crush instead of being adversely affected by it.
IV Crush: The Opportunity in Volatility
Traders can employ credit spreads, such as selling out-of-the-money verticals that have already inflated in value. This means that as volatility decreases (known as IV crush), the position gains in value.
Additionally, traders can utilise diagonal spreads to sell short-term, ‘overpriced’ options while simultaneously taking a long-term position in the same direction. In a diagonal spread, the short-term option reduces the price of the long-term option.
For those interested in a more aggressive approach, volatility arbitrage comes into play. Trading through earnings involves traders comparing the average earnings move with the current implied move, aiming to identify deviations.
For instance, if the average move stands at 8%, but the options market is pricing only 3%, this might indicate that the options market is undervaluing the options. In this scenario, going long on volatility with some long options or a long debit spread could be a prudent choice. Conversely, if the options market is pricing in a much larger move, say 20%, while the average move is 8%, it might suggest that the market is overpricing options. In such cases, a calendar spread, or a short iron condor might be considered.