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There’s more to an options contract than just the direction in which the underlying security moves. Many investors assume that if they buy a put, it will lead to profits if the underlying security’s price falls. And if they buy a call, and the price increases, they will also make money. This isn’t always true, however. In cases of implied volatility (IV) crush, a drop in implied volatility may reduce an option’s value regardless of the stock’s direction.
Investors may correctly guess which way a security will move, make the appropriate options purchase, and still lose money. That’s because the option’s value is tied not only to direction, but also to implied volatility. IV crush refers to a sudden drop in implied volatility that reduces an option’s value, even if the underlying stock moves as expected. This may happen due to the several moving parts of an options contract, which include:
• Strike price
• Expiration date
• Time decay
• Implied volatility
While the strike price and expiration date remain fixed, the other two variables vary throughout the length of the contract. This can lead to unexpected outcomes for options traders.
Key Points
• IV crush refers to a significant decrease in implied volatility following a major event, often reducing option premiums.
• Traders can incur losses from IV crush even if they accurately predict the direction of the underlying stock’s movement.
• Strategies to mitigate IV crush risks include using spreads and writing (or selling) options contracts to collect premiums and limit potential losses.
• A company’s earnings report is a common trigger for IV crush, with implied volatility typically spiking before and plummeting after the announcement.
• IV crush can lead to losses for options buyers, in particular, but can benefit sellers who collect higher premiums before the drop.
What Is IV Crush?
The term IV crush refers to a sharp drop in the implied volatility of an options contract, which can lead to significant losses in the premium. This can happen even if the trader correctly predicts the stock’s direction.
Sometimes implied volatility can drop suddenly, reducing the value of an existing options contract. This often happens after scheduled corporate events, such as earnings announcements.
Understanding IV crush in options trading starts with a closer look at implied volatility.
What Is Implied Volatility?
Implied volatility is the market’s expectation of how much a security’s price may fluctuate over a given period. The greater the implied volatility, the higher the odds of significant price movements. This idea is especially relevant when it comes to trading options, as it influences how contracts are priced.
The factors that influence the price of an option include:
• The distance between the strike price and the underlying security’s current price
• The length of time until the expiry date
• The anticipated volatility during that time (implied volatility)
Options with higher implied volatility tend to come with higher premiums. That’s because larger price swings may increase the likelihood of an option becoming profitable, which, in turn, may increase the potential value of an option.
The term “implied volatility” may be more generally thought of as the expected uncertainty in a security’s price, especially as it relates to options pricing. The more uncertainty in a contract, the higher the premium. As uncertainty decreases, so does the premium.
An option’s premium then may — at least in part — reflect the level of implied volatility investors anticipate between the present moment and the expiry date.
Premiums also tend to go up when an option’s strike price is farther from the current price of the underlying asset and when the expiry date is further into the future. With the additional time and more distant price comes an increase in uncertainty.
What Creates an IV Crush?
IV crush is a trading term meant to describe a situation where implied volatility declines rapidly. This often occurs after a significant market event, like a corporate earnings report or a product release, when market uncertainty sharply decreases.
Ahead of the event, implied volatility typically increases as traders buy calls and puts in anticipation of earnings results that may differ — either positively or negatively — from market expectations.
Then, after the event happens, many investors close their positions (an options contract can be sold or “closed” at any time before the expiry date), either taking profits or cutting losses. The result is often a sharp drop in implied volatility and a corresponding decline in option premiums, which may occur even if the underlying asset moves as expected. This is referred to as the IV crush. When the premium drops below what the trader originally paid, it could result in a loss upon exit.
Example of IV Crush
A common example of an IV crush, as mentioned above, is what often occurs when a company releases its quarterly earnings report. Each quarter, companies release earnings reports that provide financial details about their operations and profitability. Volatility often increases ahead of an earnings report amid the uncertainty of what information will be released, then drops sharply once traders have more clarity about how the company performed.
For example, a trader might buy a call option ahead of an earnings report, expecting the stock to rise. The option premium at the time of purchase might be $3.20 due to elevated implied volatility. If the stock does increase slightly after the announcement but implied volatility drops sharply, the option’s premium could fall to $2.00, resulting in a potential net loss — even though the trader was correct on the direction it took.
What Events Can Cause an IV Crush?
An IV crush could occur with any scheduled corporate (or political or government) event when the outcome is uncertain. Some other potential examples include:
• A company being granted a patent for a new product.
• A pharmaceutical product receiving FDA approval or completing late-stage trials.
• The Federal Reserve announcing a change in interest rates or other monetary policy following a scheduled meeting.
Events like these can trigger a rise in implied volatility, followed by a sharp drop once the anticipated information is released.
How to Take Advantage of (Or Hedge Against) IV Crush
Several strategies may help traders manage the risks of IV crush or position themselves for potential gains.
Strategies Seeking to Benefit From High IV
Options traders hoping to benefit from an IV crush scenario may pay close attention to the volatility of an asset in the time period before a scheduled event. When implied volatility is high, option premiums tend to be expensive. That’s when sellers may enter the trade, writing options contracts in an attempt to collect high premiums. When volatility falls, those options may be bought back at lower prices, potentially locking in profit.
Sellers may also use familiar strategies like cash-secured puts and covered calls to collect higher premiums when IV is high. Cash-secured puts involve setting aside enough money to buy shares at the strike price of a put option if the stock price falls and the option is exercised, while covered calls involve selling a call option on a stock that the trader already owns. Both strategies work best if the stock stays flat or moves modestly in a favorable direction, as this lets the seller keep the premium as IV falls.
It’s important to remember that a short options position also comes with the risk of seeing substantial losses. If the underlying stock moves sharply against the position, the trader may be forced to buy or sell the underlying asset at a loss or to buy back the contract at a much higher price, both of which could incur significant losses
Buyers, on the other hand, may prefer to enter positions when implied volatility is relatively low. Buying options ahead of a known event (when premiums are elevated) could result in losses, even if the stock moves in the expected direction. Avoiding trades immediately before these announcements may help reduce exposure to volatility-driven premium decay.
Traders anticipating a decline in market volatility may consider shorting the Volatility Index (VIX), which tracks expectations for future volatility. A decline in the VIX often reflects falling implied volatility, so traders who shorted the index during a period of high volatility may see those positions gain value as IV crush unfolds.
Ways to Manage or Hedge IV Crush Risk
Managing IV crush means understanding who’s most exposed. Buyers are generally hit hardest, as falling implied volatility reduces option premiums — even when the trade is directionally correct. Sellers — those who write options — receive a premium upfront, but still face risk if the stock moves sharply against their position. This could take the form of falling below the strike on a short put or rising above the strike on a covered call.
To hedge against IV crush, traders may use options-trading strategies that involve multiple legs, such as spreads that are intended to reduce the impact of changing implied volatility.
A spread involves buying one option and selling another to balance risk and reward.
For example, a long straddle combines a call and a put at the same strike price and expiration. Although it is not a risk-minimizing strategy, a long straddle is designed to seek profits from volatility, so it may help manage exposure to risk when large price swings are expected. A long straddle can lose value if IV drops or the stock stays flat, however.
Spreads may offer more controlled risk exposure as an options trading strategy, but they also cap potential gains.
The Takeaway
Options traders should pay close attention to implied volatility when planning the entry and exit points of a trade. Buying options before a major event may expose traders to an IV crush, which is when the implied volatility of an underlying asset drops precipitously following the event, resulting in a drop in the options’ premiums. This can happen even when the trade moves in the direction the trader expected. Using spreads or writing options contracts may help reduce risk in high-IV environments, while some traders may try to benefit from elevated volatility by selling options when premiums are high.
SoFi’s options trading platform offers qualified investors the flexibility to pursue income generation, manage risk, and use advanced trading strategies. Investors may buy put and call options or sell covered calls and cash-secured puts to speculate on the price movements of stocks, all through a simple, intuitive interface.
With SoFi Invest® online options trading, there are no contract fees and no commissions. Plus, SoFi offers educational support — including in-app coaching resources, real-time pricing, and other tools to help you make informed decisions, based on your tolerance for risk.
FAQ
What is IV crush in options trading?
IV crush refers to a rapid decline in an option’s implied volatility (IV), typically following a significant event, such as an earnings announcement. This drop in IV may reduce the option’s premium and lead to losses, even if the underlying asset moves in the anticipated direction.
How does IV crush affect option prices?
When implied volatility decreases sharply, the extrinsic value of an options contract may decline. This decrease could lead to lower premiums, which may impact traders who bought options before the IV drop and were planning to sell their contract at a profit. An option’s premium may decline as a result of an IV crush, even if the stock moved in the expected direction.
What causes IV crush?
An IV crush typically follows events that introduce uncertainty into the market, such as earnings reports, Fed decisions, or other economic announcements. Implied volatility tends to rise before these events as a result of the uncertainty about which direction an asset’s price may move, then drop sharply once the outcome of the event is known. This results in an IV crush.
How can traders mitigate the risk of losses from IV crush?
To mitigate the risk of an IV crush, traders may consider strategies such as selling rather than buying options ahead of key events, using spreads (e.g., straddles, strangles), or choosing longer-dated options. While these approaches may limit exposure to sudden drops in implied volatility, be aware that they still may come with substantial loss.
Is IV crush always a risk for options traders?
Not always. While IV crush can pose substantial risks for traders, particularly for options buyers, it may create opportunities for sellers who write contracts when implied volatility is elevated. For example, sellers who successfully sell options for a higher premium ahead of a major financial event, when an asset’s implied volatility is high, may benefit from declining premiums if the implied volatility drops after the event. Attempts to profit from high volatility comes with high risk, however.
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