A volatility crush is the term used to describe the result of implied volatility exploding once the market opens higher or lower than where it closed the previous day. For new investors, implied volatility almost always seems to rise after a stock moves in either direction. It is not that unusual for this spike in volatility to occur even when there is a small movement in the stock price. What happens next is known as a “volatility crush” as the option moves through its cycle and back towards the price of the stock.
There are many different aspects of a volatility crush to be aware of as an options trader. Among the most important terms is implied volatility, which occurs in anticipation of a major percentage move. Implied volatility will often decline just before the move happens, setting up long options bets for a profit.
This article discusses implied volatility and volatility crush, as well as several easy ways to benefit from both.
What is implied volatility, and how does it impact options pricing?
Pricing options is a complex science involving the strike price, length of expiry data, stock price, and the expected volatility in price over time. You will find more expensive options when you compare strike price to the current price (or ask to buy) and find a larger difference. Combined with the rapid increase and decrease of the demand in the market, you are creating implied volatility that options traders expect.
Implied volatility is essential to understanding the pricing of any stock or option. Understanding the curve of demand, especially leading up to earnings or big announcements, can be the difference between profiting during a volatility crush and losing your bank.
What is a volatility crush?
A fast, sharp drop in implied volatility will create a volatility crush in the value of an option. This often happens after a major event for the stock, like financial reports, regulatory decisions, new product launches, or quarterly earnings announcements.
Many traders have their eye on the volatility crush – an options trading strategy that uses both puts and calls to profit from an expected dip in implied volatility. It is often based on the idea of an earnings announcement, and more specifically, a stock’s implied volatility in the middle weeks before earnings.
For instance, in these instances, the market makers price into options (via implied volatility) substantial price action ahead of the event. This is why it is essential to understand implied volatility levels prior to initiating a trade.
If volatility is higher entering a major event, it will be more expensive to buy stock options. After the event, the price of the stock didn’t rise as much as the analysts expected, or the stock price actually went down. While, even when the price of the stock goes up, the uncertainty of price point resistance and other factors decreases the premium on the option. Therefore, the option price drops, and even though the stock may be rising, the option is not.
The disconnect between the stock movement and implied volatility crushes the options market and leaves you, the trader, with a losing trade even though the stock could be increasing.
Another instance is during a significant downside movement on the Market Volatility Index (VIX), typically a macro-level development in the market overall. A significant plunge in VIX is a trigger for traders that implied volatility is higher than historical volatility, and the resulting volatility crush is going to take your profits or turn modest winners into losers, not to mention a horrible entry.
What is an example of volatility related to earnings?
Here are two examples of how to understand volatility in the market:
- You have AAPL at a share price of $100 the day before earnings, with a straddle price at $2 one day before expiration (market expectation of 2% move on earnings day or $2.00/$100 = 2%).
- You have TSLA share price of $100 the day before earnings, with a straddle price of $15 one day before expiration (market expectation of 15% move on earnings or $15/$100 = 20%).
It doesn’t take an experienced veteran to see the difference between the market expectations for earning in these two examples. What does this mean to an options trader? Trading on the 15% scenario and selling the straddle pre-earnings, the position would be a winner if the stock never moved less than 15% on earnings day.
Conversely, trading on the 2% example, an options trader with knowledge of historical AAPL earnings reports to understand the significance of a 2% move may elect to stick with the position as a “fairly” valued opportunity.
Regardless of the strategy or scenario, understanding the historical perspective on volatility is essential to understanding options trading. This is where you find the wins, and the true opportunity of earnings comes to life. With the exception of horrible news like failed technology or company liquidation, earnings are a great opportunity to create a winning trade. Also, in these scenarios where the stock is crashing, options will go into a volatility crush. This may seem obvious and related to fear, but you can imagine this scenario easily. SPY is crashing down, and VIX is going up.
Summarizing Volatility Crush and Implied Volatility Terminology
A volatility crush is an opportunity for traders to take advantage of a pattern of predictable price movement across the options market. When you understand premium rates increasing during a substantial event (like earnings) followed by the decrease in implied volatility, you can make smarter trades, informed positions, and better moves for your overall account.
For any trader, implied volatility (IV) is one of the most important considerations because it has a direct impact on pricing. It’s even more important now as IV spreads have grown significantly wider, and the concept of a “volatility crush” has become an increasingly viable options trading strategy. It has been my experience that implied volatility increases before an earnings announcement and that this increase is due to option writers who want to ensure adequate protection of their portfolios from significant price fluctuations in the market.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.