Implied Volatility Crush: A Primer

Earnings season is in full swing, and many traders are gambling on huge earnings beats or misses, and if you find yourself being one of those people, let’s make sure we understand this concept known as IV crush.

Let’s pose a scenario: You and a couple others do some serious DD on a company for their upcoming earnings report the next day at close. You come to agreement “they’re going to beat” and you pray the stars align for you.

Next day, you buy calls on ticker XYZ, 5% OTM in hopes for a beat. Market close happens, and the earnings are about what was expected, and the next day ticker XYZ opens 1% higher, however, your calls are down 50%. This is IV crush.

But what is actually happening mechanically?

IV crush usually happens around a binary event, such as earnings reports, or potentially an insanely hyped product launch (re: Tesla battery day).

When these binary events approach, market makers have to price volatility into the actual price you pay for the option. They have to hedge their risks in case a stock jumps or dumps 40%, so they do that by inflating the premium on the contracts.

For the sake of the argument, NVDA has earnings on February 16 after close. The image below shows a glimpse into what this pricing looks like.

We can see that the IV is higher for next week’s expiration, simply because earnings are approaching. I would expect this to continue to increase into the actual date of the announcement.

The supposed “crush” comes from the absence of realized volatility, so the pricing on the contracts deflates drastically. This is a seller's dream and a buyer's nightmare.

You can think of implied volatility as future volatility, and once the earnings have settled and we see a given range, the future volatility will decrease as the market is not pricing in a scenario where the stock will randomly jump 40%. This is removing the prospect of a big move, thus “future volatility” is much lower, and so are the prices of contracts.

If you’ve had skin in the game for a while, you’ve probably seen people talking about both calls and puts increasing in value despite the share price being the same, or moving in the other direction. This, again, is a byproduct of market makers having to price in potential moves.

So, how do we trade it?

Well, if you haven’t picked up on it by now, selling (or writing, for you proper nerds) options before one of these events /typically/ yields a decent return.

Of course, you run the risk of the underlying stock jumping 40%, but you’re paid to take that risk in terms of premium value.

But what about for buying? How would we play this?

Well, this comes down to calculating what a stock’s “expected move” was. I know some of you just got flashbacks to high school statistics and expected value, but don’t worry, this is much more simple.

How do you find a stock’s expected move?

You take the price of an ATM straddle (long put and long call on the same strike), and multiply by .85. For NVDA, an ATM straddle is currently trading at 25.25. 25.25 * .85 = ~21.5. This is roughly a 9% move.

If you buy an ATM call to hold through earnings, and NVDA stock doesn’t move more or less than 9%, then you will experience IV crush, and your contract’s worth will drop a fair amount.

How do you avoid this? Well, first and foremost, betting on ER's is a sure fire way to light money on fire. However, should you want to play earnings like this, lottos are the way to go. The contract pricing in relation to IV doesn’t have as much effect outside of that 9% range.

So, if you're buying longs for an earnings report, make sure you check the expected move. If you're selling options for an earnings report, also make sure you check the expected move.

That's all for this; thanks for reading. Please dm me with any questions you may have on twitter https://twitter.com/falcon_fintwit

Hope you all learned something today :)