What Is IV Crush?

This can happen with any significant event, e.g. an FPA approval date, the outcome of a legal battle, etc. We’ll work through a conceptual example to see how this plays out.

Say that a company is due to report earnings soon, and a number of market participants believe that actual earnings will end up being higher than what is currently expected. In order to capitalize on this forecast, the market participants buy a number of calls ahead of the announcement. At the same time, some market participants believe actual earnings will end up being lower than expected, and so they buy puts.

With no consistent view of the future, a sudden surge in demand for both puts and calls is created, which pushes up volatility as both sides hope to make a profit from the announcement. Eventually earnings day arrives and the company releases its results, which means the market now has certainty on the company’s true earnings.

As a result, traders rapidly re-evaluate their positions and decide whether to hold or close their positions. Many traders will be hoping to lock in profits or stem further losses (depending on their original stance), so they’ll rapidly close their position. With the market having increased certainty, volatility drops very quickly, resulting in an IV crush and a steep decline in the value of options.

This dynamic occurs even when company earnings reports are bad, because ultimately what matters is not what the results were, but that there are now results which allow for an increased level of certainty for investors.

To protect yourself against volatility crush, there are two key actions you can take. The first is to avoid trading options where the expiration month contains an earnings announcement. It is in the expiration month containing an earnings announcement that traders are at the highest risk of a volatility crush, as stocks will be re-priced as a result of the announcement.

The final way is to pay close attention to an option’s historical volatility, to compare whether implied volatility is relatively high compared to historic norms. If you discover implied volatility is higher than historic norms, avoid buying options on that stock until implied volatility settles back down.

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Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are ...

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