Understanding What Is an IV Crush and Its Implications for Options Traders

There are few certainties in the life of an option trader, but the fact that the implied volatility of an option will regularly crush after a major event linked to the company is among these. If you are not familiar with the concept of IV crush, there’s a lot you should know about it. This event can give you an opportunity for trading, but it could also hurt your portfolio. Let us look at the main points you should know about an option’s IV crush in today’s guide.

Key takeaways

• IV Crush is a significant drop in implied volatility that typically occurs after the announcement of earnings or significant corporate events. This rapid decrease can greatly affect the price of options.
• The effect of IV Crush is particularly noticeable post-earnings. IV often rises before the announcement as investors expect larger than normal stock price movements.
• Avoiding earnings announcements and implementing risk-defined plans and proper position sizing can help you manage the IV Crush effect on your trades.

What Is an IV Crush?

When it comes to IV in options trading, an expression that you will surely have already heard is “IV Crush.” But what does this term mean? The IV in IV crush stands for implied volatility, and the term ‘crush’ signifies a rapid drop. Thus, an IV crush in options refers to a sudden decrease in implied volatility, which typically follows significant corporate events, such as earnings announcements.

If you ask yourself “why does an IV crush happen?” and “what’s the effect of an IV crush on the market?”, you’ll find out most of the information you should know about this event. Before an earnings announcement or similar event, implied volatility tends to rise. This increase is due to investors anticipating a larger than normal price movement in the stock, which in turn leads to higher options prices. However, once the news is out and uncertainty diminishes, the implied volatility drops rapidly, leading to a decrease in options prices. When this happens, you are dealing with an IV crush or “implied volatility crush.”

Observing an IV crush after earnings is quite common. For example, stocks like Apple (AAPL) and Nvidia (NVDA) frequently exhibit IV crushes in options following their earnings announcements, and this is true for a large number of companies. Despite a sometimes minimal change in their stock prices, most companies experience a noticeable drop in implied volatility following these events, reflecting the market’s reduced uncertainty about these companies’ future performance.

IV Crush – Opportunity or Risk?

While an implied volatility crush can lead to lower options prices, it also presents opportunities for options traders. When implied volatility is high, options are more expensive. Therefore, a drop in implied volatility and options pricing can benefit options sellers (you are shorting an option, so you obviously want its price to drop). However, it’s worth noting that trading during periods of high volatility can be risky, regardless of the side of the market (buyer vs. seller) that you choose..

So, how to avoid an IV crush? Some traders use automation or risk management strategies to mitigate its effects. Others rely on risk-defined strategies, proper position sizing, and combining high implied volatility opportunities with other indicators to profit from an IV crush.

We have a section dedicated to this topic at the end of the article. For now, let us try to study the phenomenon from a practical point of view with several examples, as shown in the next sections.

IV Crush After Earnings – A Classic Scenario

One of the classic scenarios we will look into is that of an IV crush after earnings. Prior to this type of announcements, uncertainty tends to build up, inflating the implied volatility and, subsequently, the price of options.

However, once the announcement is made, the uncertainty dissipates, causing the IV to plunge. For now, consider this: an IV Crush can leave option holders nursing significant losses if they’re not prepared.

Volatility Crush in Option Trading

“Volatility crush” and “implied volatility crush” are two sides of the same coin:

• IV crush refers specifically to the rapid decrease in implied volatility of an option.
• A volatility crush can refer to historical volatility, which is the “real” volatility of a stock price. In general, you will observe that movements in implied volatility tend to anticipate those of the real volatility. 

What Is an Example of an IV Crush?

If you wonder, “What is an example of an IV crush,” let us walk you through two scenarios that illustrate the impact of IV Crush on option prices.

Visualizing the IV Crush with Two Examples

Firstly, let’s consider Accenture (ACN). On September 28th, 2023, Accenture published its latest earnings report, which unfortunately disappointed the market. However, the focus here is not on the company’s performance per se but rather on the consequent reaction in the options market.

As you see below, there was a sudden, significant decline in implied volatility (the green line from the image in our options screener) immediately following the earnings report. This is a textbook example of an IV crush in options. Regardless of the (negative) interpretation given by the market to the earnings report, the removal of uncertainty surrounding the company’s performance led to a sharp decrease in option prices. This is, indeed, a classic IV crush phenomenon.

Our second example is Nike (NKE), which also released its earnings report on the same day as Accenture. Unlike Accenture, Nike managed to positively surprise the market with its earnings report. Yet, interestingly, this radically different situation led to the same outcome in the options market: a strong decline in implied volatility.

The graph below shows you the IV crush that happened after NKE’s earnings. Even though the earnings surprise was positive, the resolution of uncertainty led to a decrease in option prices.

These two examples tell us a great deal about the IV crush phenomenon: it does not matter whether an earnings report was positively or negatively interpreted by the market. What matters is that the market received a clear message that reduces the level of uncertainty and speculation surrounding the earnings announcement event, leading to an IV crush.

Understanding this phenomenon is crucial for options traders, as it helps them choose the best way to avoid an IV crush after earnings. It’s clear that the impact of IV crush extends beyond just the change in the mathematical value of expected volatility. We can tell you more about the implications for options trader in the next section.

IV Crush Meaning – The Implications for Options Traders

By now, you should have understood that an IV Crush can have significant implications for options traders. In this section, we’ll look more closely into what an IV Crush means for options traders, how it impacts the pricing of options, and how traders can navigate this event.

At its core, an IV Crush (or “implied volatility crush,” a concept you surely memorized at this point), refers to a rapid drop in implied volatility after a significant corporate event such as an earnings announcement. This change can greatly impact the pricing of options, creating both counterintuitive scenarios and profitable opportunities for traders.

How IV Crush Can Impact the Pricing of Options

When implied volatility is high, options prices tend to be inflated. This is because options sellers demand a higher premium for taking on the increased risk associated with high (expected) volatility. However, once the uncertainty surrounding an anticipated event fades, implied volatility drops rapidly, leading to a decrease in option prices (all other factors being equal) – this is the essence of an IV Crush. It’s worth noting that while high IV in options often ends up moving down lower, this isn’t always the case, as volatility is not so easy to predict.

Counterintuitive Scenarios on IV Crush Options

IV Crush can sometimes lead to counterintuitive scenarios in options trading. What do we mean by this? Well, consider our case study below, where we take a look at asimple call option. 

Once again, we ask ourselves “what is an example of an IV crush?”. In this case, a theoretical case study will help us understand this concept in a quick and effective manner.

A Case Study: Call Option Behavior in a Rising Stock Market

Imagine a scenario where a trader buys a long call option on Stock XYZ, priced at $100, expecting a positive move following an earnings announcement. Let’s say they purchase a call option with a strike price of $103 for $5.

Now, if the stock indeed jumps significantly, but the option’s price remains flat or even declines, it can be attributed to a decrease in implied volatility (which is, indeed, the IV crush).

In this hypothetical scenario, even with a 7% increase in the stock price, the option price might not reflect the expected profit. This is due to the impact of IV Crush, where the implied move priced into the options before earnings is higher than the actual move in the stock.

The decline in option prices following the earnings announcement may catch a trader by surprise. So, once again: it is essential that you take into account the fact that, every once in a while, an IV crush will occur. 

Strategies to Profit from IV Crush

Good traders can find a way not only to avoid an IV crush as a risk, but even to profit from this. That’s right: even though it is far from easy, you can theoretically profit from an IV crush. 

This section will look into various strategies that options traders can use to exploit an IV Crush and discuss the risks associated with shorting high volatility options.

The Various Strategies that Options Traders Can Use to Exploit IV Crush

• Selling Straddles: This involves selling both a call and put option with the same strike price and expiration date. If the underlying security’s price remains relatively stable, the rapid decrease in option prices post-event can generate profits for the seller.
• Iron Condors: This strategy involves selling a call spread and a put spread simultaneously. Traders can profit from the decrease in implied volatility while limiting their risk exposure.
• Calendar Spreads: By selling short-term options and buying longer-term contracts with the same strike price, traders can benefit from the rapid decrease in implied volatility following an earnings announcement.
• Butterfly Spreads: This strategy involves buying a call spread and a put spread with the same strike price and selling further out-of-the-money call and put options. Traders can profit from IV crushes if the underlying security’s price remains within a specific range. It also has limited risk, so even if you are wrong, it will have limited effect.

As a general note, you should also consider that you may simply want to buy an option and close it before the company’s earnings. If you think about it, IV tends to move upwards as we approach earnings, right before crushing. This tendency – which is not always true, but it represents a frequent case – can lead option premiums to increase before earnings.

Risk Considerations

While these strategies can yield substantial profits during an IV Crush in options, it’s crucial to be aware of the potential risks.

Shorting options with high IV can be profitable during an IV Crush. However, it’s important to remember that high volatility can lead to even higher volatility, and volatility tends to cluster. Therefore, shorting high-volatility options can be a really bad idea in the wrong market environment. Implementing risk-defined strategies, proper position sizing, and other risk management techniques are crucial to mitigate potential losses (once again, refer to the dedicated section toward the end end of the article).

Leveraging an Option Screener

Navigating the world of IV Crush can be challenging, but an option screener such as ours can make the process easier to grasp. Specifically, here are some tools you could find useful:

• Implied Volatility Analysis: Detailed information on implied volatility levels for different stocks and options, including IV percentile, historical graphs, skew, and more.
• Stock scenario: The feature will check – through Monte Carlo analysis – which is the best option strategy assuming a scenario you can input in the tool.

Furthermore, you will be able to see important information about the options in the database, such as their IV rank and a company’s next earnings date.

Let’s consider an example using our options screener to illustrate how one might execute an IV Crush trade.

Step 1: Leverage the “Earnings” Predefined Scan

First of all, click on “Earnings” in the predefined scan section. This feature will allow you to filter out options with upcoming earnings announcements, a key trigger for an IV crush.

Step 2: Choose the Strategy that Fits Your Needs

After running the scan, the platform will present you with a list of potential strategies. You can choose between selling iron condors or buying straddles based on your risk tolerance, market outlook, and trading preferences.

Step 3: Start Trading

Once you’ve selected a strategy, check out all the options located by the screener. Evaluate each trade idea carefully by sending it to your trade log for further analysis.

When you’re ready, you can execute the trade by sending it directly to your broker or simply entering it into the platform’s trade log. We suggest entering paper trades as well so you will have statistics you can analyze and improve for the next earnings season.

How to Avoid an IV Crush

We told you a lot of things about the IV Crush phenomenon, but it is now time to learn how to avoid it (if possible).

When looking for “how to avoid IV crush” online, the most common advice you’ll find is to avoid trading options around earnings or significant corporate events. However, this approach can significantly limit trading opportunities for traders who rely on volatility to generate profits.

Can you actually handle an IV crush event? You can, it’s not easy, but you can. We’ll tell you more below.

Managing Your Risk

The main answer to how to avoid an IV Crush is that you need to adopt robust risk management strategies. These can include implementing risk-defined strategies, coupling high implied volatility opportunities with other indicators, and carefully considering expiration dates.

Importance of Risk-Defined Strategies

Risk management is paramount in options trading, especially when facing an IV Crush scenario.

Define the Best Strategy and Find the Proper Position Sizing

One of the most critical aspects of this planning involves defining the best strategy and finding the proper position sizing to manage risk effectively. This is especially crucial when dealing with an IV Crush, where rapid decreases in implied volatility can significantly impact trade outcomes.

The secret to an effective risk management strategy in options trading is the implementation of risk-defined strategies. Basically, you are setting a limit on the maximum risk exposure for each trade. This means that before entering any trade, traders need to establish clear risk parameters. These parameters act as a safety net, ensuring that potential losses are kept within acceptable bounds.

Position sizing is also something into which you want to look. Appropriate position sizing means determining the number of contracts or the amount of money you are willing to put at risk in each trade. This decision should be based on a careful evaluation of your risk tolerance and overall investment goals. By employing proper position sizing, traders ensure they do not overexpose themselves to risk in any given trade.

Implementing risk-defined strategies and proper position sizing can provide a robust defense against the potential pitfalls of an IV Crush in options. When facing an IV crush after earnings, option prices can plummet. This can lead to substantial losses for traders. 

Keep Your Eyes on the Risk-Reward Ratio

Another crucial element to consider is the risk-reward ratio. This ratio is a measure of the potential profit from a trade compared to the potential loss. A favorable risk-reward ratio means that the potential profit outweighs the potential loss. By carefully evaluating the risk-reward ratio before entering a trade, you can increase your profit probability in the options market.

Therefore, defining the best strategy and finding the proper position sizing are key to successful options trading. Through the implementation of risk-defined strategies, appropriate position sizing, and careful evaluation of the risk-reward ratio, traders can navigate the challenges posed by events like an IV Crush. This approach allows traders to manage risk effectively, protect their capital, and increase their chances of profitable trading in the volatile world of options.

Considering Expiration Dates

The significance of expiration dates in your options contracts becomes evident when you look at an IV Crush event. Consider the guiding principles below to better understand how expiration dates work in this context:

1. Options with expirations before a significant event will remain largely unaffected, as the implied volatility will already reflect the known information.
2. Options expiring closest to an event triggering IV Crush, such as an earnings announcement, will experience the most substantial impact of IV Crush – as there is new information and not much time to expiration.
3. As you move further in time from the event, the effect of the IV crush diminishes gradually.
4. Options with more than three months to expiration tend to be minimally affected, if at all. This is attributed to the likelihood of another earnings event occurring within that time frame.

Therefore, while IV Crush can be intimidating, understanding its dynamics and employing smart risk management strategies can help you face its challenges effectively.

Making Sense of the Implied Volatility Crush

Understanding IV Crush (implied volatility crush) is crucial for options traders, given its potential to significantly impact the profitability of a trade. A steep fall in implied volatility following a major event, like an earnings announcement, can turn a promising position into a loss.

However, the strategies discussed in this guide, including implementing risk-defined strategies, leveraging indicators, and careful consideration of expiration dates, can help traders not only mitigate the risks associated with an IV Crush but also potentially profit from it.

Now that we know what is an example of an IV crush and how to manage it, it’s time to put this knowledge into practice and strive toward success in the world of options trading. Finding a good implied volatility level, for instance, is a fundamental aspect to grasp in your daily options trading activity.

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