How is it possible to lose money on an investment when you’ve correctly guessed the direction of the security you purchased?
Implied volatility crush, or IV crush, is the culprit here. And if you want to trade options in a safer way, it’s a good idea to be aware of what IV crush is. IV crush is essentially when the implied volatility of a security literally gets crushed, caused by a myriad of reasons related to investor psychology.
You can never have full certainty with investments in the market. Before events happen, you can do everything you can to prepare, but still guess wrong. But in the case of IV crush, we’ll teach you enough to where you can guarantee your safety, and if you play it right, even use IV to generate some gains.
Let’s dive into the specifics of this unique aspect of the complex world of options.
What you’ll learn
- Implied Volatility Explained
- What is Implied Volatility Crush?
- An Example of Implied Volatility Crush
- When Does an IV Crush Happen?
- In-Depth: IV Crush and Earnings Reports
- How IV Crush Impacts Options Trading
- Can You Use an IV Crush to Your Advantage?
- How to Avoid the Downfalls of an IV Crush
- LEAP Options and IV Crush
Implied Volatility Explained
In the world of trading, implied volatility (IV) is a mathematical metric that is used to help understand the likelihood of fluctuations in a security’s price. You can think of IV essentially as a measure of uncertainty in the form of a percent. Understanding this metric is helpful in trading because you can use it to assist in assessing risk, as well as having a better idea of an options premium.
The more implied volatility there is, the riskier the investment is predicted to be. So with more uncertainty, there will be a higher IV, and visa versa. But remember that it is implied, so you can also think of it as a measure of probability.
IV is used in pricing option contracts, along with other key elements used to create an options premium. This makes IV one of the primary tools options traders use when they make investment decisions.
Let’s dive a little deeper to better understand why IV is so useful to investors, and why it gets crushed as a result of various factors.
What is Implied Volatility Crush?
Implied volatility crush, more commonly referred to as IV crush, is when an option’s premium plummets as a result of a decrease in an option’s implied volatility. This decrease in IV is actually due to the underlying security’s price increasing. So as share price decreases, IV increases because of a lack of investor confidence, which increases volatility.
The same goes for the other direction – if the share price increases, IV decreases. We’ll get more into the “why” a little later. But for now, let’s talk about how it’s possible to lose money on an investment even after successfully predicting the direction of the underlying price.
This concept can be confusing, because we’ve heard time and time again, “buy low, sell high”. What happens is, as the share price increases, investor uncertainty lowers, causing IV to decrease, which lowers its extrinsic value. And earnings reports are notoriously known for being one of the primary factors contributing to an IV crush, which we will also discuss in more detail.
Essentially, IV tends to get crushed when earnings reports are released because certainty about the underlying price is very high, thus decreasing volatility.
An Example of Implied Volatility Crush
Let’s use Johnson & Johnson (JNJ) as an example, and say they’re trading at $150.00. Investors know that JNJ is about to announce earnings, and as that release date nears, IV is on the rise as uncertainty grows.
Earnings are set to be released at the beginning of the second quarter, April 1. On March 31st, one day before the earnings report, investors have the highest level of uncertainty in the underlying stock price because they know earnings will affect the price, they just can’t be completely sure as to how.
On April 1st, earnings are released. Let’s say in this example earnings were much higher than expected. Investors are happy, and this causes the stock price to rise. And, now that the earnings report is essentially factored into the price of the stock, and investors are more bullish on its direction, IV plummets, or gets crushed. There is virtually no uncertainty in the price anymore, and the stock’s price is on the rise. With both factors directly affecting IV, the result causes it to be ‘crushed’.
When Does an IV Crush Happen?
An IV crush can happen as a result of a few key factors, but the chief reason is typically due to a sudden decrease in an options premium and the underlying price of the stock, again as a result of a change in investors’ level of certainty. Investors want certainty in their investments, but they almost never have it. So IV gets crushed when earnings reports are released, because investors are much more certain about the price of the security, and more certainty lowers volatility.
This is why movements of the underlying share price and the IV are inversely related. Think about it like this: if the market, or if a stock price starts to fall, the psychology of the market changes, people get more worried. This causes volume to increase, perhaps because investors begin buying put options to hedge against the decline, and or they sell what they currently long to prevent larger losses. Basically, in such an environment, investors are frantic.
When the activity of the market increases like this, volatility goes with it. And the market is typically more volatile when people are panicking, versus when investors are feeling more comfortable when they watch a stock price steadily increase, therefore lowering volatility.
Still confused? Let’s use a metaphor to help explain it in a different way. Think about the COVID pandemic. When things are moving in a good direction, the number of deaths, new cases, and hospitalizations are going down; this causes people to be more comfortable, less panicked, and things aren’t as volatile. But, when new cases start spiking, hospitals start filling up, the number of deaths is going up, people start to panic, causing things to be more volatile.
The same process happens in the market, and this is why IV and the direction of the market or price movements of individual securities are inversely correlated.
In-Depth: IV Crush and Earnings Reports
Let’s talk about earnings reports and why they cause an IV crush. When earnings are released, if they’re much higher than expected, that means that there is less uncertainty in the pricing of the underlying security. So as uncertainty gets less and less, volatility follows suit, as we’ve touched on above.
As time progresses, and the earnings release date gets closer and closer, investor uncertainty gets higher and higher. Everyone’s just a little unsure how the earnings report will go, and you feel that pressure as you approach the release of the news. So, after earnings are released, investors have more certainty in the price of the security, causing IV to get crushed, which lowers the premium of call options.
The above example is a year-to-date chart (Feb 16, 2021 – Feb 16 2022) of Amazon (AMZN) showing IV in yellow, and a 30-day moving average of IV in blue. The circled parts indicate when earnings reports were released throughout the year. You can see in every example that the acute change is huge, while the average stays pretty consistent. This clearly demonstrates the effects that earning reports have on IV, and therefore options premiums.
How IV Crush Impacts Options Trading
Unfortunately, in many cases, the impact of a change in volatility can outweigh a correctly anticipated movement of the underlying share price, causing you to actually lose money. We talked about that before, but why is that?
The basic idea of how IV affects an options premium is this: as IV increases, so does the option premium; as IV decreases, the option premium follows. Thinking about this further, the higher the volatility, the larger the potential price fluctuations can be, thus increasing the potential for larger gains. This is attractive to investors, so the options premium is affected because people are generally willing to pay more for a contract that has a potential to have higher profits.
A critical consideration in options trading is to steer clear of buying calls, especially when the underlying share price is relatively low, as this can trigger options trading alerts. You can look at the average underlying share price over a given period of time to give you a good idea of whether it’s relatively higher or lower.
Statistically, it is more likely for the underlying price to increase when it is below average (e.g. nearing its 52-week low), which could cause the option premium to decrease, shedding potential profits you were hoping for.
So in the case of buying options, it’s imperative that you are aware of where the current share price is relative to its mean, as it may actually be more advantageous to invest when it is above its mean, rather than below (underlying price decreases, IV increases, thus premium increases). But this is a tricky play and requires more research and practice.
As a quick side note: when we say “mean” or “average”, we’re referring to a moving average. And this moving average is the security’s average price over a set period of time (i.e. 30 day moving average, 60 day moving average, etc.). It’s a good idea to look at different moving averages to give yourself the best idea of a relatively high or low in the underlying security’s price.
Can You Use an IV Crush to Your Advantage?
IV crush can certainly be used to your advantage. The key, however, is understanding the nitty gritty, what we’ve discussed above – how movements in the IV, underlying share price, and option premium are intimately connected. “You have to learn the rules of the game. And then you have to play better than anyone else.” – Albert Einstein. You don’t need to be Einstein to use IV crush to your advantage—but you do have to understand the details.
We know that the option premium and IV are directly correlated, and we know that IV has a tendency to plummet after earnings reports. With that understanding, we can infer that it would be more statistically viable, and safer, for you to purchase contracts after earnings are released rather than before. So if an options premium goes down after earnings, you can reasonably assume that you’re buying the contract at a ‘discount’. This is one of the best ways to use IV crush to your advantage.
The other side to the coin is what to do before earnings are released. From a statistical point of view, it’s a good idea to take advantage of IV crush by selling call options before earnings are released. So, many traders opt to buy calls, for example, when IV is relatively low, and sell them when it is relatively high, bearing in mind earnings play a huge role in the movement of an option’s IV.
How to Avoid the Downfalls of an IV Crush
You can hedge against an IV crush through various different strategies. One easy method is to understand what the average implied volatility is over a set period of time. Looking at just the percent IV is not very helpful, because a 33% IV for one option could mean something very different for another option. What is helpful is to understand what the average is, and how far above or below the current IV is.
How do you apply this concept to trading options? Using the mean like we had discussed before, you could avoid IV crush by making sure you don’t long positions when the underlying share price is relatively high, and the earnings report is approaching imminently. When IV is higher than its mean, the underlying share price is increasing, and the earnings report is coming up soon, that may very likely be the perfect storm to cause a punishing blow to your profits.
Another method to avoid IV crush is to be aware of other events that might cause huge price swings, because it’s not just earnings that influence investor confidence. The government increasing or decreasing interest rates (which affects investor confidence), elections, and changes in corporate management, etcetera. All of these events can affect the market heavily, and huge swings in underlying share prices will tremendously influence IV.
So the takeaway with this tip is, it’s safer to just avoid trading during or before these events. You can always check out an economic calendar if you want to see when some of these events will happen.
LEAP Options and IV Crush
LEAP options, or Long-Term Equity Anticipation Securities, have an expiration date of longer than one year. This exposes the contract to large price movements that could happen within that large amount of time.
We’ve discussed how, in an attempt to avoid the downfalls of IV crush, one of the best methods is to trade after earnings are released. But in the case of LEAP options, any contract you long will have to weather the storm of multiple IV crushes. This is something to consider when buying these, especially after understanding what we have discussed above.
We can’t say with full confidence whether it is a good idea or not to trade LEAPs knowing that IV crush will play a role in the direction of the investment. Obviously many investors do it. But what we can say with full confidence is that you should understand the ins and outs of IV crush before purchasing LEAPs, mostly because you can open yourself up to more risk, which isn’t always a bad thing, just something to be aware of.
In conclusion, the psychology of the market, specifically investors’ level of certainty, is what lies at the root of understanding IV crush. Investors gain or lose confidence through a number of different factors. One of the most influential and predictable factors is the date earnings are released. Knowing what the underlying company’s earnings are gives investors confidence, so the closer you get to the date, the less certain investors feel, and right after they’re released is the most certainty in the underlying price that investors experience.
We also talked about the relationship between an options premium, its IV, and the underlying share price. IV and premium are directly correlated, and IV and premium tend to be inversely related to the underlying share price.
By understanding the relationship between these factors, and being cognizant of what we have discussed here regarding market psychology, you can know that you have a really good idea of what IV crush is, how to avoid it, and even how to use it to your advantage.
How IV Crush Works: FAQs
What’s the Benefit of IV Crush?
There are benefits to IV crush, but it depends on the perspective you choose to look at it.
On one hand, IV crush can crush your profits. Shedding any potential profits you hoped to make, even when you correctly guessed the direction of the underlying price.
On the other hand, however, if you are aware of this dangerous pitfall and have understood what has been written above, you can capitalize on IV crush. Finding sly disguises of opportunity for purchasing ‘discounted’ contacts and protecting your precious capital.
How Do You Trade IV Crushes?
There are a few ways that you can trade IV crush. The most common way is to understand what factors cause IV crush to occur, and then strategically plan your trades around that. This means not buying calls right before an earnings report and instead waiting until after IV is crushed, thus lowering the premium.
It is generally a good idea to think about selling contracts when IV is high, and buying them when IV is low. So follow the downhill slope of the IV crush, and then jump on the opportunity to buy contracts that have premiums that are relatively lower.
But before you even start trading on the wave of IV crushes, do some due diligence before. Choose a couple contracts that you want to monitor, and without buying them, observe their change in premium and IV before and after major events that affect the market and that individual underlying security. Keep a trading journal and gather this data over time to increase the effectiveness of your decisions as an investor.
Does IV Go Down After Earnings Reports Are Released?
IV has a tendency to go down after earnings reports are released. This is because IV is a measure of suggested volatility. Volatility is higher when uncertainty is higher, because people are less confident with the market or the price of an individual security. Knowing what a company’s earnings are, despite the fact that they may be higher or lower than expected, creates certainty. Right before earnings are released, there is the most uncertainty, and therefore the most volatility (IV), and right after they’re released, there’s the most certainty. Restoring investor confidence, causing IV to plummet.
How Long Does Implied Volatility Last?
How long implied volatility lasts has to do with standard deviation. Here’s a quick stats 101 lesson as it applies to investing and IV: standard deviation is the range of potential price movement of a stock, and IV represents that potential price movement in the form of a percent (if a stock is trading at $100.00 and has an IV of 20%, its range is $80 – $120), and statistically, the price movement can deviate from its starting price within that range 68% of the time over the course of one year.
Can You Avoid IV Crush?
You can absolutely avoid IV crush. There are some circumstances in which it is unavoidable, but generally, if you understand the factors at play that cause IV crush, you will have a much higher chance of avoiding it.
Most circumstances where it would be unavoidable have to do with news that affects a stock’s price, and or changes the direction of the market. IV is lower in bullish markets, and if there is positive news that creates a more bullish market, you might not have enough time to react to the news, where you’d want to sell your position before IV is crushed.
One example of this positive news could be the sudden announcement of a change in management within the underlying company, or maybe the company just signed a contract with another company, increasing their value tremendously. This can cause the stock price to skyrocket, and IV to plummet, and you can do little about it unless you are very quick to react.
Many factors that influence the movement of IV can be predicted though, and we’ve talked extensively now about earnings reports being one of the chief factors.
Can You Profit From IV Crush?
You don’t necessarily profit from IV crush, but rather, you can profit in its aftermath.
What we mean is, after IV is crushed, as we’ve talked about a few times now, premium also gets crushed. When options premiums are really low, you can purchase contracts after a crush to have a higher chance of profiting from that contract. Much, much more so that you would by buying the contract before the crush.