IV Crush: Implied Volatility Crush Explained

IV crush stands for implied volatility crush and goes along with a sudden drop in previously increased implied volatility. An IV crush happens when the anticipated move on an underlying stock does not occur. Let’s say, a scheduled news event like earnings announcements, or planned FDA approvals don’t lead to the anticipated sharp rise or drop for the price per share. Such a situation causes an Implied Volatility crush.

A volatility crush is triggered by s sharp decrease in option volatility. It even happens during sideways markets when market participants expect a potential movement in the underlying stock. Then out of a sudden, absolutely nothing happens to the price per share. For example, an earnings announcement from Apple (NASDAQ:AAPL) is scheduled for today after the market close. Before the announcement, the implied volatility goes higher because market participants expect a gap up or gap down on the next market open.

Then, the earnings results do not cause any movement, and the gap on the next day is around 0%. As a result, the options premium will drop because of the implied volatility drops. After all, the stock does not move anywhere. Before an earnings announcement, you can also notice unusual options activity caused by institutional buying and selling of options, and some of the best options trading alert services utilize the power of an IV Crush trading setup day trading options.

What is Implied Volatility?

Options trading means handling kind of insurance policies. Those are mainly being used by institutions to protect their investments. But also day traders and mid-term investors can benefit by trading options. The implied volatility affects the option price of call options and puts.

It is crucial to understand that the implied volatility is a frequently changing variable and not gradual. This makes it pretty hard for option trading beginners, to deal with. Yesterday I read a story from a finance blogger who lost 53k due to market volatility in April 2020. That’s why it is important to learn from the best options traders and to apply the strategies learned.

The IV gets triggered to an exponential curve when:

  • The market expects a sharp move because news is scheduled
  • Price gaps to the upside or downside happen due to news like an FDA announcement, or earnings report.

The more sharply a move is expected, or the stronger the price changes, the higher the implied volatility goes.

Volatility Crush Trading Strategies

Let’s summarize what we talked about so far:

Scheduled news events and surprising news events trigger sharp market movements or trigger sharp market movements expectations.

Sharp market movements or expectations cause an increase in implied volatility.

An increase in implied volatility causes the option premium going higher since investors are willing to pay a higher price for the “insurance.”

If the anticipated movement doesn’t happen, then the implied volatility faces a sudden drop.

A sudden drop in implied volatility causes the IV crush.

The selling option premium is one of the most frequently used IV crush trading strategies. The idea is to sell the option short to others as long as they are willing to pay a high price for the option premium. But it is also one of the most misunderstood strategies in the options market.

Option buyers limit their risk by the number of options * 100 * options premium (US options). This is true for buying calls and buying puts. But selling options means an unlimited risk for the option seller if the options are sold naked. Holding a naked call or naked put overnight is riskier than gambling in a casino.

 It is like going to the private backyard casino and asking the owner to give you credit because you have the best hand in poker you ever had, and it is 100% sure that you will win. But then, even if the math was done right, the other player wins the pot, and you lost the money you brought to the table, plus you now owe a ridiculous amount of money to someone else.

That leads us to two important factors when it comes to IV crush trading strategies; first educate yourself by learning based on reliable free resources, or by participating in the best option trading courses; second practice under any circumstances first with a trading simulator or paper trading account.

Conclusion

A sudden drop in implied volatility causes IV crush. It mainly happens when an expected strong price movement did not happen as awaited. As a result, the option premium drops significantly, along with the stock price, and opens opportunities to make money on the change in the option price. Option buyers lose money when they hold a call or put option contract during an implied volatility crush.

The best ways to make money with the IV crush is by day trading the option contracts by selling options for the premium and protecting it by either close intraday stops, or protection position with stocks, or options with another strike price or expiration date.

The implied volatility crush often happens after an earnings announcement and causes option prices to drop. The market volatility index VIX can also initiate a crush of implied volatility from a broader market perspective. The higher the broad market VIX, the higher the general option premium, plus the higher the volatility of a related stock, the higher the implied volatility.

IV Crush Questions and Answers

  1. How do you stop an IV crush?
  2. What is a high IV?
  3. How much does IV drop after earnings?
  4. How to avoid IV crush?

How do you stop an IV crush?

Enter an options trade when the IV is low. The IV is low when planned catalysts like earnings are weeks away, and if the broad market VIX is low. This holds true for buying calls and puts.

What is a high IV?

An IV of 50% means that the market expects a volatility of 50% until option expiration. Talking about an option for a stock with a price per share at $100 indicates that the market expects +-$50 price movements per share.

How much does IV drop after earnings?

The IV drop depends mainly on the earnings results. The less the market moves after the earnings announcement, the more the implied volatility will drop when the market opens.

How to avoid IV crush?

There is no straightforward way to avoid it. That’s why it is crucial to consider the implied volatility before buying calls or puts. Investors can protect from the impacts of an IV crush by hedging the position.

Updated: April 23, 2020

About the author: Alexander is the founder of daytradingz.com and has 20 years of experience in the financial markets. He aims to make trading and investing easy to understand for everybody, and has been quoted on Benzinga, Business Insider and GOBankingRates.