Implied Volatility Crush: The Silent Trader Killer

Implied volatility crushes often occurs after a major event that spikes IV

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    Understanding IV (implied volatility) Crush is crucial for options traders because it is a key component of option pricing. 

    In this article, we will explore the concept of IV Crush in options trading. We will begin by defining implied volatility and its importance in options trading. Then, we will discuss what IV Crush is, how it occurs, and the factors that can cause it.

    What is IV (Implied Volatility)?

    Implied volatility (IV) represents the market's expectation of the level of volatility that will be realized in the future for a particular stock or index. IV is crucial to understand as an options trader since it significantly affects option pricing.

    When implied volatility is high, this signals people are expecting a large move in the stock. Therefore, options are more expensive since people are speculating on a significant move by purchasing options contracts.

    On the other hand, when implied volatility is low, options are much cheaper since people don’t feel the need to actively hedge or speculate on a large move. 

    Options with a higher IV are more expensive because they have a greater chance of ending up in the money, and vice versa. As a result, traders must be aware of the current IV levels to assess the fair value of an options contract and determine if it is overvalued or undervalued.

    What is an IV Crush in Options Trading?

    Implied volatility crush, or IV crush, occurs in the options market when the implied volatility of a stock rapidly decreases. This can happen for various reasons, such as changing market conditions or stock-specific news. 

    IV crush often occurs after a major event, such as an earnings report or a news announcement that caused IV to be elevated.

    The extrinsic value of an option is dependent on the IV, so when an IV crush occurs, the extrinsic value drops significantly. A drop in IV indicates that traders no longer expect a significant move causing option prices to decrease. 

    Earnings announcements are one of the most significant events that can lead to an IV crush. Earnings reports tend to bring uncertainty, and investors tend to anticipate a larger than normal move in the stock's price.

    How to Calculate the Implied Move

    The implied move is how much an underlying stock is expected to move over a period of time. It is often used in options trading to help traders make informed decisions about which options contracts to buy or sell.

    You can calculate a stock's implied move by determining the price of an ATM straddle. If you want to find the implied move of an earnings or news event, you should build the straddle on the expiration date right after the event. 

    For example, if a stock is trading at $100, you would buy the $100 call and put to build a straddle. Say the total cost of the strangle is $10. This means the expected move of a stock for that expiration cycle is $10. 

    If the underlying stock stays within the implied move, option sellers will win, and option buyers will lose. 

    If you believe a stock will not move outside of its implied range, you would sell options. If you believe that IV is understated and the stock will move outside of its implied range, you should be a buyer of options. 

    It's important to note that calculating the implied move is not an exact science, and it's not a guarantee of how the stock will move. However, it can provide a good estimate of the potential price movement, which can help traders decide whether they should buy or sell premium.

    IV Crush Following Earnings

    Earnings announcements can significantly impact the underlying stock's price and the expected volatility, leading to an IV Crush.

    When a company releases its earnings report, the market will react, causing the stock to sell off or get bought up, depending on whether the earnings were better or worse than expected. This can cause the stock price to fluctuate significantly, affecting the implied volatility of options contracts on that stock.

    Before an earnings announcement, traders generally buy more options than usual, causing IV to increase. When a stock releases earnings, several investors may change their minds about the stock depending on how the earnings look, which causes more uncertainty than usual. 

    After the earnings announcement or news is released, implied volatility (IV) tends to drop quickly and significantly as the unknown becomes known, and the stock price reacts to the information. This drop is called IV crush.

    How to Profit From the IV Crush

    The most common way to profit from IV crush is to sell options before a company reports earnings. If a trader believes implied volatility is overstated, they can profit by utilizing short volatility strategies like the iron condor or short strangle. 

    To implement this strategy, you would find a stock reporting earnings in the near future. Next, you would sell a strangle or an iron condor on the expiration date following the earnings announcement. 

    Iron Condor

    The iron condor involves selling an OTM call and put and buying even further OTM calls and puts to make it a defined risk trade. An iron condor benefits from IV crush if the stock stays within the implied move, allowing you to generate a quick profit. 

    However, if the underlying stock moves further than its expected move, the iron condor will lose money, and you may take a loss. Having a plan for when trades become losers is crucial to managing your risk. 

    Short Strangle

    The short strangle is similar to the iron condor, as it involves selling OTM calls and puts. However, the short strangle doesn’t include buying any options, making it an undefined risk trade. 

    The short strangle allows you to collect more premium but is significantly riskier as the risk is undefined. Therefore, if the underlying stock moves substantially further than its expected move, you can take a significant loss. While each strategy offers opportunities for traders to profit from IV Crush, they also come with risks that traders should be aware of.

     

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