Don’t be a victim of implied volatility (IV) crush: Part 1

Your favourite tech company, TechAi, will report earnings tomorrow and you’re convinced the news will be exceptional. However, from what you’ve read, it seems the market is skeptical and might be surprised by anything better than mediocre. In your estimation, this could mean that TechAi’s price could move quite a bit higher.

TechAi is currently trading around $49. You’ve done some technical analysis, and you believe good news could push the stock’s price over $50 and perhaps into the mid $50s area. This is an estimate, of course, and a few things have to come together to make that happen. But you feel as certain as you ever have that this is a trade worth taking.

You decide to do an option trade and buy some call options to capitalize on this idea. You buy 10 TechAi calls with an expiry date that’s 2 weeks in the future. With TechAi trading at $49, you choose a strike price of $50 and pay $3 per option. All that’s left is to wait for tomorrow’s earnings announcement and find out if your analysis pays off.

The next day, you’re up bright and early to check TechAi’s earnings announcement. Yes, you were right — the earnings are great, much better than expected, and the market is reacting positively to the news. The stock has risen just over 5% to $51.50. You congratulate yourself on your insightful analysis as you check the option’s price and notice that your $3 option is now trading for $2.50! What happened?

If you’ve been educating yourself on options and options trading, you may have heard the term “IV crush.” This is exactly what happened in the situation just described. The “IV” in IV crush is implied volatility, a measure of how much option traders are plumping up the option’s price because they believe the option could become more volatile in the coming period. This belief could be based on an upcoming event, something specific like an earnings announcement, or something broader like the outcome of a major election. It could also be a reaction to an ongoing increase in volatility in the stock, sector or market as a whole.

From time to time, traders express their belief or fear that elevated volatility in the underlying stock will continue. How do they do this? By making the options more expensive.

When option buyers are willing to pay more, and option sellers want more premium to take on the risk of being short the option, the option’s price rises. Both the buyer and the seller are acknowledging the increased chance that the underlying stock could move in an atypical way. As a result, option prices increase. Because other inputs to the option’s price have not changed, the higher price is attributed to increased IV. The higher price implies that traders believe higher volatility is a possibility going forward — thus the term implied volatility.

If a particular event has been causing IV to rise, the need for a higher option premium disappears once the event takes place. In other words, once the uncertainty is gone and traders know what happened, the higher IV premium that compensated for the potential higher volatility is no longer necessary. This is largely why TechAi’s call option price dropped even though the stock rallied nicely, as forecast. Note that, in this scenario, it’s likely that the IV of both puts and calls increased before the earnings announcement and dropped after. Increased volatility can move a stock’s price to the downside as well as the upside.

Want to know more? Read Don’t be a victim of implied volatility (IV) crush: Part 2.