IV Crush

IV Crush

 IV crush stands for implied volatility crush and is a description of what happens to options vega premium when it drops dramatically out of the pricing model of an option chain. This usually happens after a major risk or news event has passed for the underlying stock or market for the option contract. The most common time to see IV crush in a stock option is after an earnings announcement for the underlying company. 

Vega in the options pricing model tries to project the potential move after earnings into an option price. Option sellers have to be compensated for the uncertain risk of the potential future price action of a stock after earnings. An IV crush occurs because after the event has passed the option contracts stop pricing in risk and the option returns closer to prices reflecting the historical implied volatility for the stock. 

The at-the-money options in an option price chain reflects the full pricing range for the implied move in a stock after earnings, If a stock is trading at $100 a share and the $100 strike call option and $100 strike put option (front month) are trading at $22 ($2200 for a 100 share contract) the day before the earnings announcement then a approximate $20 move in the stock is priced into vega  if the contract is usually $2 a contract ($2 is theta). Implied volatility is directionally neutral so both calls and puts price in the vega premium. The magnitude of a move is priced in but not the direction. 

In the above example, if after earnings the stock opens up at $120 then the $100 strike call option will be priced at approximately $220 ($2200 for a 100 share contract including theta). In this example the vega premium is priced out but has been replaced by intrinsic value as the at-the-money call option has gone $20 in-the-money after earnings. This surprises many new option traders as they think they made $20 a share but they just broke even as the addition of the intrinsic value only replaced the lost vega value post earnings. 

It is difficult to make money buying options and holding through earnings as the implied volatility is already priced in. To be profitable on a long options play through earnings the intrinsic value gained after earnings has to be enough to more than replace the lost vega and you must get the direction correct. Many option traders prefer to sale option premium before earnings like short option straddles or short option strangles to profit from IV crush. With that type of short option play it is crucial to hedge the risk with long farther out-of-the-money options in case there is an outsized parabolic move beyond the parameters of the vega pricing. 

After an earnings announcement the implied volatility pricing curve for the vega value of an options chain is crushed. 

IV crush is the market acting efficiently by pricing in the option chain the potential move of a stock post earnings. 

IV Crush
Chart Courtesy of TrendSpider.com

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IV Crush