Don’t be a victim of implied volatility (IV) crush: Part 2

You can see an option’s current IV value in “Option Details” on the Investor’s Edge platform. You’ll need to compare it to the history of IV for this stock to understand whether that value is inflated and by how much.

If the options you’re considering have inflated IV, what steps can be taken to address it?

1. Sidestep the issue

One obvious answer is to avoid trading options around an earnings release. This lets you sidestep most common instances of IV crush and may be the right choice for you. This won’t work for everyone though — some option traders want to capitalize on the increased volatility around an earnings announcement. They may be able to identify potentially lucrative option trading strategies and want to actively trade around those dates.

Also remember that it’s not just earnings announcements that can produce inflated IV. Any pending news that the market believes could produce an atypical price move — a new product announcement or an FDA decision for a drug company are examples — could result in inflated IV and likely IV crush after the event. Although a successful trade is still possible when IV crush occurs, the stock needs to move more to overcome the option price contraction when IV deflates after the event.

2. Be an option seller when IV is inflated

One way to avoid, reduce or take advantage of IV crush is to use strategies that involve both buying and selling options, such as vertical spreads or iron condors.

These strategies all contain one or more legs that benefit from a decline in an option’s price. They can help reduce the impact of IV crush by offsetting the losses from an option that you’re long, with the gains from another that you’re short. Alternatively, you can focus just on strategies that involve selling options, such as covered calls, short straddles or short strangles. Note that these strategies may involve higher risks and may require more capital and margin.

To find out more and decide whether these are right for you, check out our course on How to trade options. It includes detailed descriptions of all these approaches.

3. Focus on strike price and expiry date

In the money (ITM) options are likely to experience the smallest price inflation before a volatility event and will likely lose a smaller percentage of their value when IV deflates after the event. However, some option traders prefer out of the money (OTM) or at the money (ATM) options. This is largely because these options will be less expensive, and their percentage gains will be comparably larger if the trader is correct and the stock makes an extraordinary move. Although the chances of extraordinary moves are low — this is why they’re called extraordinary — they can happen.

The same principle applies to options with a shorter versus longer time to expiry. Shorter-dated options, as long as their expiry date is after the volatility event, are the most susceptible to IV crush and most reactive to price moves in the underlying stock. They’ll gain more on a percentage basis, compared to longer-dated options, if the stock makes a large move in the predicted direction, all else being equal. They’ll also lose more if it doesn’t.

Note that these strategies will likely require more capital or margin. Because you may have more capital at risk overall, you may lose more if your stock forecast is incorrect and the trade moves against you — even though these strategies are generally less susceptible to IV crush.

Although an option’s IV tends to decline after an event like an earnings announcement, there are occasions where the stock’s volatility continues to increase even after the event. This is most likely to happen when investors are surprised by something in the company’s report. Aggressive buying or selling, or both, can pick up as new information is factored into the stock price. While IV crush is likely after an earnings announcement, it’s not a given. IV could remain elevated or even increase in the following period.

To address IV and IV crush, consider steps that include shorting options. This could be as a standalone strategy or in addition to buying options. It’s undertaken to potentially benefit from the short option’s declining price due to IV crush.

To minimize possible losses from IV crush, you may want to look at trading with ITM versus ATM or OTM options and longer versus shorter expiry dates. While these strategies are generally less susceptible to IV crush, they require that you put more overall capital at risk, and this may result in higher losses from incorrect stock price predictions or timing. Finally, you might avoid options trading around earnings announcements or other volatility events.

In some fairly rare cases, stock volatility and option IV will actually increase, rather than decrease, after an earnings event. This can happen when investors are digesting previously unaccounted for bullish or bearish information. In this situation, long holders of OTM options with short expiry dates will benefit the most.