IV Crush: Avoiding an Implied Volatility Earnings Crush
The Implied Volatility crush. In this post, we discuss the danger of an options IV crush, especially during earnings season, and how to avoid it. As well as three exciting strategies to take advantage of options iv crush.
An options IV crush is a dangerous event during earnings season. IV crush happens when there is a sudden and unexpected drop in the implied volatility of options contracts. When IV Crush happens, it can be challenging to make money trading options, especially if you are not prepared for it. This blog post will discuss the danger of an Options IV Crush and three strategies that you can use to take advantage of it!
The 1% of Earnings Options Trades
We have all seen the screenshots and felt the FOMO after seeing someone on Wallstreetbets make over 1,000% on an earnings options play (example below). While this does make the idea of putting money on black 35 attractive, this is NOT the norm. From my experience and talking to hundreds of traders, trading around earnings is a zero-sum game.
While there are huge moves overnight, premarket options already have priced-in these moves. This results in an IV crush the next day, and inside this blog, we will attempt to address what it is and how a trader can put themselves in a position to take advantage of it.
Earnings Announcement Affects
An earnings announcement typically produces a huge single-day move in the stock and sometimes can alter the long-term momentum. For example, every four months, a company releases revenue numbers, cash balance, profit margins, and more. In addition, companies will drop important news on dividends, buybacks, hirings, new products, and more. These statements make it very dangerous to trade a stock, especially an option.
While the company earnings announcement may not be anything special, the stock will react violently to adjust the price to the new news if any news is not priced in or currently known. Typically, the market prices everything, but any recent information can quickly throw off the market. The market and analysts have an idea of the projected earnings, but the actual earnings can be much different.
Implied Volatility Explained
Before discussing how to take advantage of options implied volatility crush, let's first explain what implied volatility is. Implied volatility measures the expected future price movement of a security's price.
It is calculated by taking the current market price of an option and dividing it by the absolute value of the theoretical options pricing model. This number tells you how much the market expects the security to move in the future.
Every option has a different value for implied volatility, which is significantly higher for options before a company earnings report. These inflated options are a considerable danger for options traders and a massive opportunity for option sellers... let's discuss.
Priced in Earnings Movements
As we stated before, when a company releases its quarterly earnings, the stock often makes a significant move in one direction or another. This possible move is already priced into the cost of the option. This means that unless the stock moves more than the priced-in move, the option buyer will have a 99% chance of losing money. The only scenario where the option buyer profits from a company earnings move are only if the actual movement is larger than the priced-in move.
Example of a Priced-In Move
In the example below, we can find the priced-in move for Telsa the week before earnings by creating a straddle. A straddle is created by buying a long call and long put at the money. The straddle price of these two options can be a good gauge for the priced-in earnings move for Tesla. Below we can see that the straddle price is $96, which means Tesla is expected to move around 10% after the earnings are released ($96/$936).
This could be 10% higher or lower, which is the problem trying to buy options during this time. Not only is this a huge move, but the option buyer would need a move larger than 10% to profit. In the stock that happens to close between $843 and $1043, most of the options for calls and puts will expire totally worthless at the time of expiration.
Vega Affects on the Options Price
When implied volatility decreases, the option contract's price also decreases because of vega. Vega measures how much the cost of an option contract's price will change in response to a one percent change in implied volatility. This means that when implied volatility decreases 1%, the cost of the options contract will also reduce by the amount of vega.
Example of Vega
As you can see for the options contract below, the high implied volatility is 100%, and vega is 0.48 the week of earnings for Tesla. If this high implied volatility were to drop to 80%, that would be a 20 point drop, and if we multiply that by vega. It would affect the options price by $10, given the current price of the option at $45, which is a little more than a 20% loss in value just from a volatility contraction. The truth is most options drop in IV after earnings, hence IV crush.
Increased IV Before Earnings
Looking at a Telsa options contract just one expiration month further out, we can see the future volatility is 73%. As a result, options close to expiration the week of earnings will typically have a higher IV. A higher implied volatility means more extrinsic value, which means the option buyer pays a massive premium for the options contract.
Intrinsic value is related to how much the option is worth at the time of expiration. Which is related to how far it is in the money. All options out of the money expire worthless regarding extrinsic and intrinsic value. Extrinsic value is the option's intrinsic value minus the current option premium price. Most options are made up of 80-90% extrinsic value compared to intrinsic value, which only goes up the further the option is out of the money.
The option contract is always a combination of extrinsic and intrinsic value, and the goal is to have as little extrinsic value as possible. Still, when implied volatility is 50% higher during earnings, this means you are paying higher premiums. The main reason for this increase is due to what we stated earlier, the expected move. This does increase the IV a lot as the options traders are trying to price the option before earnings correctly. The higher the predicted move, the higher the IV.
Implied Volatility Crash Explained
Now that we understand IV, Vega, and earnings, let's go over IV crush in-depth. The Options IV Crush is often caused by a sudden and unexpected sharp drop in the implied volatility of options contracts. Option price inflation is mainly due to the trader's pricing options with a particular magnitude move before earnings.
This, unfortunately, raises the contract's implied volatility. So the very next day, when this move happens, the IV tends to get crushed and normalize. The goal of the option traders was to prepare for a particular movement that elevates the option's prices. Once the move happens, there is no need to pay a higher premium for options as the action has already happened.
Dangers of an Earnings Volatility Crush
One of the biggest dangers of an IV crush is correctly predicting the direction of the stock but not the magnitude. As we stated earlier, if the stock doesn't move further than the expected priced-in move, the option traders will lose money even if they were correct about the direction. Another considerable danger is being wrong in the direction.
Being wrong on the direction could result in the option opening up the next day way past the traders stop loss, or worse, 90-99% loss of value. So while trading options during earnings can seem attractive, this is a real possibility traders need to be aware of.
How to Take Advantage of an Options IV Crush
Now that we know what an Options IV crush is and some of the reasons why it can happen, let's discuss how to take advantage of it. At this point, you are probably seeing the opportunity of being short of these options instead of long.
The amount of options going to zero during earnings season is quite significant. That is why finding a strategy to play the other side correctly is so attractive. If you are unfamiliar with selling options, it is the act of shorting an option with the hope of the value going to zero.
As stated previously, a sharp decline of 90-99% in value can happen the very next day in the options prices. This decline means an option selling can collect almost an entire profit overnight, sometimes with an 80-90% chance of success depending on the strike price chosen.
The first strategy you can use when the implied volatility of options contracts drops is writing covered calls. A covered call is an options strategy where you sell a call option while owning 100 shares of the underlying stock.
When the implied volatility of options contracts drops, you can write covered calls to take advantage of the decrease in implied volatility. An option seller can also take advantage of time value decay which is inevitable daily.
Covered Calls Example
In the example below, if a trader owned 100 shares of Tesla, they would sell one call option at any strike price. The further away from the strike price, the higher the chance of profit but the smaller the profit.
The closer the strike price is to the stock price, the lower the chance of profit and the higher the possible yield. For example, in the option chain below, you can see that an option with an 80% chance of profit could return $1,893, which is around a 1.5% possible return on capital. On the other hand, if the stock options trader was OK with a 76% chance of profit, the profit could increase to $2,580 for the $1,000 strike.
Cash Secured Puts
Another strategy that you can use when the implied volatility of options contracts drops is cash-secured puts. A cash-secured put is an options strategy where you sell a put option and buy the underlying stock. When the implied volatility of options contracts drops, you can sell cash-secured puts to take advantage of the decrease in implied volatility.
Cash Secured Puts Example
In the example below, if a trader owned the capital to buy 100 shares of Tesla they would be able to sell one put option at any strike price. The further away from the strike price is from the stock price the higher chance of profit but the smaller amount of profit.
The closer the strike price is from the stock price the lower the chance of profit and the higher the possible profit. In the option chain below, you can see that an option with an 80% chance of profit could return $1,365 which is around 1% possible return on capital.
Selling Iron Condors
The final strategy you can use when the implied volatility of options contracts drops is selling iron condors. An iron condor is an options strategy where you sell a call and put option and buy a call and put option. When the implied volatility of options contracts drops, time passes, or the stock trades sideways, the price of iron condor decreases, WHICH IS GOOD.
As an option seller, the decay of an option is the goal. Iron condors are two credit spreads, one put and one call. A credit spread is created by selling an option with more value and buying an option with less value.
The difference in the option prices creates a credit that the option seller will look to collect in hopes of the value dropping to zero by the time of expiration. The benefit of an iron condor is that the credit received can be twice as large because it is two credit spreads, while the risk is the same as putting on only one credit spread.
Both legs of the iron condor being 20% apart make it impossible for them both to be assigned simultaneously.
Selling Iron Condors Example
From the example below, we can see that the iron condor has a credit of $663 with a possible loss of $337. This is an excellent risk to reward of 2:1, which doesn't often happen for iron condors. All that needs to happen is Telsa needs to stay between the break-even prices of $883 and $996 by the time of expiration.
While the price in the move is further away than these iron condor legs, the trader can easily adjust the legs to offer a lower risk to reward. The main point is the iron condor is an overall strategy that can be played during earnings to help the trader profit from an IV crush, lack of movement, and inherent time value decay.
Wrapping Up - In Conclusion
Corporate earnings can be a very dangerous time to trade options due to the iv crush. The actual earnings release is a significant event for the stock that can cause a very steep decline or rise. More often than now, the stock will fail to move further than the expected move which is the main reason the implied volatility lowers and causes the iv crush.
While buying options can be extremely risky due to the high chance of lost money there certainly is an opportunity with selling options. The three opportunities discussed were covered calls, cash secured puts and iron condors.
These allow traders to collect premiums from the implied volatility crush. The next time a company's earnings date approaches you now should have enough strategies to take advantage of this major event.
Use BreadAlerts to Maximize Option Selling
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