What Is Implied Volatility (IV)?
Implied volatility is a metric used to forecast the likelihood of movement in a security’s price. IV is quite useful in projecting a few things such as future price moves, supply and demand and pricing options contracts.
Also, we have several factors that come into play when calculating implied volatility. But two of the major determining factors are supply and demand; along with time value.
Implied Volatility & Options Trading
Implied volatility is often used to price options contracts. High implied volatility results in options with higher premiums and vice versa.
As you probably already know, we use two components to value an option contract; intrinsic value and extrinsic value. If you’re new to options and this sounds Greek to you, the extrinsic value represents the “risk premium” in an option. We have an options course on our website; you can check out for more information.
Furthermore, when the perceived uncertainty of a stock’s price is increasing, we see a rise in demand for option contracts in that security. That was a mouthful, I know.
When this scenario happens, the extrinsic value of the options increases in value. And this translates to a rise in implied volatility. Typically, this scenario plays out as a company’s earnings date get’s closer.
What is IV Crush
IV crush is the phenomenon whereby the extrinsic value of an options contract makes a sharp decline following the occurrence of significant corporate events such as earnings. Unfortunately, this implied volatility crush catches many options trading beginners off guard. Buyers of stock options before earnings release is the most common way options trading beginners are introduced to the Volatility Crush. It’s often confusing because sometimes your option may have gone ITM but you still lost moment due to how high the IV was when you bought the option, versus the price of the premium when the event occurs and the IV dies.
When Do We Commonly Experience an IV Crush?
Typically, an IV crush happens when the market goes from a period or an event of unknown information to a period or an event of known information.
In simpler terms, IV rises in anticipation of an event and falls after the event. Personally, I would say the best example of this is an upcoming earnings event. This is what people here refer to as playing earnings. In most cases, if you are good at choosing direction or playing strangles, people will buy a couple weeks or more before earnings, ride the IV ramp, and sell before earnings. They do not hold through earnings. This avoids the crush. More on that shortly.
IV Crush After Company Earnings Are Released - Explained
Companies are veiled in secrecy, yet we get a glimpse under the veil during earnings day. Every quarter, public companies release their earnings and the market participants eagerly anticipate this date.
This is why implied volatility in options tends to pick up before the “big” announcement and decrease significantly immediately after the announcement.
Generally speaking, if the market participants think the actual earnings will be higher than expected, they will buy calls hoping to profit from the announcement.
Alternatively, if they think the actual earnings will be lower than expected, they will buy puts. Once again, the underlying reasoning is the same; they hope to profit from the announcement.
In other words, the combination of call and put buyers push up volatility in anticipation of an actual earnings “surprise.” Finally, one earnings day comes, and earnings are released, these trades are closed – and closed very quickly.
The combined result of the selling lowers volatility – hence, The IV Crush A striking feature of all this selling is a steep decline in the option’s value.
Worth mentioning, if you intend on buying LEAPS or longer term option holds for future growth or events in mind, you want to wait until after earnings or a time of low IV to purchase those. This will allow you to avoid any long term IV crush you may experience due to buying at a time of high volatility.
Good or Bad, Earnings DO Matter
Whether the earnings release brings us good, bad or even new information, this time allows us to re-value the stock. And unless the company is planning some major event in the future (i.e. putting themselves up for sale), uncertainty decreases. And this is where the magic happens. Because humans love certainty, decreasing uncertainty decreases volatility.
Now it is important to pay attention to what I have to say here: When stocks make large moves down after earnings, the underlying options still experience a volatility crush. I know this seems counter intuitive because equities tend to be inversely correlated to fear.
Take, for example, the S&P 500. Normally when the S&P goes down, we expect VIX to go up. However, this is not the case at earnings. Even a bad report still gives us valuable insight into the company’s operations.
No matter the direction, this information allows a stock to be re-priced. Either way, uncertainty reduced, and implied volatility drops. And this couldn’t be more true in the expiration month containing earnings.
Remember, as Conq and the smarts always warn, news and earnings can trump TA or patterns always. So don’t get too hung up on technicals in times of high volatility. There’s always what we expect a ticker to do, and what a ticker is actually doing. The latter is most important.
Final Thoughts
As you can see from the above, IV Crush is an important part of options trading. In general, earnings volatility is a dynamic event with many moving parts. Luckily, it offers vigilant traders many opportunities to profit.
And remember, if you hold through earnings, your parents don’t love you.
Feel free to add examples with pictures for the visual learners or your own experiences.
Information is from experience, educational articles/materials, and members here.
I’ve attached some videos to help those that learn better visually.
