Volatility Crush in Options: What You Need to Know and How to Benefit from It

Volatility crush might sound dramatic, but in the world of options trading, it’s a regular occurrence. It often follows a significant event such as earnings reports, product launches, or regulatory decisions. Picture this: You've bought options anticipating that the volatility surrounding a company's earnings announcement will lead to a significant price swing. The event comes, but instead of making money, you notice that the value of your options has plummeted. This is volatility crush in action, and it can catch even experienced traders off guard.

What Is Volatility Crush?

At its core, volatility crush refers to a sharp decline in implied volatility (IV) in the price of an option, which typically occurs after a significant event. Options traders often use implied volatility as a measure of the expected volatility of an asset. Before an event like earnings, traders anticipate larger price movements, causing implied volatility to rise. Once the event is over, the uncertainty diminishes, and implied volatility drops—often sharply. This sudden drop is what we call a volatility crush.

Implied volatility significantly impacts the price of an option. As it rises, so does the price of the option, regardless of whether the underlying stock price moves. Conversely, a drop in implied volatility can cause a significant decrease in the option's value, even if the stock price doesn’t move much. This is why many options traders find themselves losing money even when they correctly predict the direction of the stock price.

How Does Volatility Crush Impact Options?

To fully grasp how a volatility crush affects options, let’s take a closer look at the components of an option’s price:

• Intrinsic Value: This is the difference between the current price of the underlying asset and the option’s strike price. If an option is “in the money” (ITM), it has intrinsic value. If it’s “out of the money” (OTM), it does not.

• Extrinsic Value: This includes time value and implied volatility. As implied volatility rises, so does the extrinsic value of the option. Similarly, when implied volatility drops after an event, this extrinsic value can drop sharply, resulting in a volatility crush.

Now, let's imagine you're holding a call option on a stock with high implied volatility ahead of earnings. If the stock moves as expected after the earnings announcement but implied volatility drops significantly, the value of your option may still decline. This is because the drop in implied volatility outweighs the intrinsic value gained from the stock price movement.

An Example of Volatility Crush

Let’s consider an example using a popular stock like Apple Inc. (AAPL):

• On the day before Apple announces its quarterly earnings, the implied volatility of Apple’s options might rise due to the uncertainty surrounding the report. Let’s say you purchase a call option with a $150 strike price. The stock is trading at $145, and the option’s price includes a significant amount of extrinsic value due to the elevated implied volatility.

• After the earnings report, Apple’s stock moves to $150. Although the stock has risen, the implied volatility drops from, say, 40% to 20%. This drop in implied volatility significantly reduces the extrinsic value of the option, resulting in a volatility crush. Even though the stock moved in your favor, the value of your call option might still decrease due to the sharp decline in implied volatility.

In this case, the volatility crush has negated the potential profits from the stock’s price movement.

The Role of Earnings in Volatility Crush

One of the most common triggers for a volatility crush is an earnings announcement. Companies typically report earnings every quarter, and these reports can cause significant stock price movements. Traders try to predict whether the company will beat or miss expectations, leading to a surge in implied volatility before the earnings report.

But here’s the catch: once the earnings are announced, the uncertainty disappears. The stock might not move as much as expected, or it might even move in the predicted direction, but the implied volatility drops sharply. This post-event collapse in implied volatility is the essence of a volatility crush.

Traders who don’t account for this potential drop in implied volatility can find themselves losing money on options trades, even if they correctly predicted the stock’s direction.

Why Do Traders Care About Volatility Crush?

Understanding volatility crush is crucial because it helps traders make better decisions when trading options around significant events. Without this knowledge, it’s easy to get caught up in the excitement of pre-event speculation, only to be disappointed when implied volatility plummets after the event.

By factoring in the potential for a volatility crush, traders can:

• Avoid Overpaying for Options: Traders can avoid paying inflated premiums for options with high implied volatility by waiting for the volatility to settle after the event.
• Use Volatility Crush to Their Advantage: Skilled traders might sell options during periods of high implied volatility, benefiting from the subsequent volatility crush.

For example, selling straddles or strangles—strategies where traders sell both a call and a put option—can be particularly profitable if a volatility crush occurs. These strategies thrive when implied volatility is high because the trader collects premium from both the call and the put options, and the subsequent volatility crush allows them to buy back the options at a lower price.

Strategies to Mitigate the Impact of Volatility Crush

If you’re looking to avoid being burned by volatility crush, there are several strategies you can use:

1. Avoid Buying Options Before Major Events

If you know an earnings report or similar event is coming, and implied volatility is already elevated, it may be wise to avoid buying options. Instead, consider waiting until after the event when implied volatility drops and options are more reasonably priced.

2. Sell Options to Capitalize on High Implied Volatility

Selling options when implied volatility is high can be an effective way to capitalize on a volatility crush. By selling options, you collect the premium from buyers who are paying inflated prices due to high implied volatility. When implied volatility drops after the event, the options become cheaper, allowing you to buy them back at a lower price.

3. Use Spreads to Reduce Risk

Option spreads—strategies that involve buying and selling options simultaneously—can help reduce the impact of a volatility crush. For example, a vertical spread involves buying one option and selling another option with the same expiration but a different strike price. The premium collected from the sold option helps offset the cost of the bought option, reducing the overall impact of a volatility crush.

Here’s how a bull call spread might work:

• You buy a call option with a lower strike price.
• You sell a call option with a higher strike price.

In this case, if implied volatility drops, the loss in the value of the bought call may be offset by the gain in the sold call, mitigating the impact of the volatility crush.

4. Use Implied Volatility Rank (IVR)

Implied Volatility Rank (IVR) measures where the current level of implied volatility stands in relation to its historical range for a specific stock. For example, if a stock has an IVR of 80, it means that its current implied volatility is higher than 80% of the observed levels in the past. Monitoring IVR helps traders assess whether options are overpriced or underpriced due to implied volatility. High IVR signals that implied volatility may be elevated, increasing the risk of a volatility crush.

5. Plan for Post-Event Trades

Sometimes the best way to play a volatility crush is to wait for the event to pass and then trade based on the aftermath. Once implied volatility drops, option prices can become more attractive, and you may be able to capitalize on any price movements that occur post-event.

For example, instead of buying options before earnings, you could wait until after the report and take advantage of the post-event environment, where implied volatility has normalized and prices are more reflective of actual risk.

Conclusion

Volatility crush is a critical concept for options traders, especially those trading around earnings reports or other major events. By understanding how implied volatility works and how it can collapse after an event, traders can avoid the pitfalls of overpaying for options and even use volatility crush to their advantage.

Whether you’re selling options to capitalize on high implied volatility or using spreads to mitigate risk, knowing how to navigate volatility crush can make a significant difference in your trading performance. It’s all about being aware of the potential for volatility to drop after a major event and planning your trades accordingly.

Armed with this knowledge, you can approach options trading with greater confidence and avoid the common traps that ensnare many traders. And who knows, you might even learn to love volatility crushes as they become a key part of your trading strategy.