Earnings announcements and significant corporate events like product launches or clinical trial results lead to increased implied volatility before the event.
After the news is released, implied volatility (IV) tends to drop quickly and significantly as the unknown becomes known and the stock price reacts to the news.
This drop is called IV crush.
What is IV crush?
Traders “bid up” volatility before earnings announcements. Why? Stocks tend to make their most volatile moves around earnings dates. Earnings results, forward guidance, and management’s commentary can send a stock flying or sinking.
These reports bring uncertainty. So, implied volatility rises before the event because investors anticipate a larger than normal move in the stock’s price.
Let's look at two examples of IV crush after earnings with AAPL and NVDA. You can see implied volatility drop after each of Apple's earnings announcements, despite any significant price change.
Again, with Nvidia we can see the same scenario. The IV crush is clearly visible the day of the earnings release.
Remember, implied volatility is the expected price movement in a security over a period of time.
IV is one of the most important factors impacting an option’s price. Higher implied volatility means higher option premiums.
So, buyers of options benefit from increasing implied volatility while options sellers benefit from decreasing IV.
Implied volatility rises before earnings and makes all option prices more expensive. Immediately following the earnings announcement or news, implied volatility drops (since the uncertainty of the news is now known), causing an option’s price to drop.
Implied volatility's rise in anticipation of earnings is like inflating a balloon. All the buildup and activity leading up to the event is like blowing up the balloon. Once earnings are released, implied volatility drops rapidly like letting the air out of the balloon.
How do you calculate the implied move?
You can calculate a stock’s implied move by determining the price of a straddle for the closest expiration after earnings. The straddle is the market’s expectation, or implied move, for the stock.
For example, if a stock is trading at $100 the day before its earnings announcement and the combined price of an at-the-money (ATM) call and put is $5, the stock’s expected move is $5 or 5%.
If the stock moves less than $5 in either direction, then the actual move of the stock was less than the implied move.
Even if the stock moves outside the expected range, implied volatility typically still decreases.
The pitfalls of IV crush
Consider this example: your favorite stock is getting ready to announce earnings. You buy a long call because you are confident the announcement will surprise and the stock will rise.
Fast forward: you are right! The stock jumps 10% on strong earnings, yet your long call option is flat on the day. How can this happen? How could a call option be flat (or even down!) on the day a stock is up 10%?
If the actual move is less than the implied move priced into the options, then the decrease in implied volatility can significantly compress an option’s price following the earnings announcement.
So, even though the stock went in your predicted direction, implied volatility dropped dramatically, causing the option’s price to decrease.
You can use automation to avoid earnings announcements. (Which you may want to do after hearing this podcast).
Is it possible to make money from IV crush?
Profiting from IV crush
Implied volatility is mean-reverting. IV spikes are often followed by a return to more normal levels.
When implied volatility is high, options are more expensive. Likewise, a drop in implied volatility and options pricing is profitable to options sellers.
If the underlying security does not move as much as expected (which is often the case), the rapid repricing of options generates a profit for options sellers.
Take the example above of the $100 stock. If you sold the straddle for $5 and the earnings move was less $5, you could buy back the position for a lower price and profit from the decrease in implied volatility.
It’s important to note that not all high implied volatility conditions resolve lower as expected. High volatility can lead to higher volatility.
Volatility tends to cluster. What may seem like an advantageous options selling opportunity could be the beginning of prolonged volatility.
Shorting high volatility options can be ruinous in the wrong market environment. Remember, all option contracts have an expiration date. Sustained periods of high volatility could last longer than your position’s duration.
Yes, at some point, volatility will subside. But if it doesn’t happen before expiration, you’ll be forced to buy back the position for more than you sold it.
Risk-defined strategies, proper position sizing, coupling high implied volatility opportunities with other indicators, and other risk management strategies must be implemented when trying to profit from IV crush.