Have you ever seen implied volatility drop so quickly that it killed your trade? Try these risk management ideas to manage volatility crush.
Say you’re convinced a stock will move to the upside. Premiums on the stock’s out-of-the- money options are relatively high, so what’s there to lose? Well, in the options world, things don’t necessarily work out as planned. Many factors could catch you off guard, and a big one is a “volatility (vol) crush.” If you’ve been trading options for a while, you’re probably smirking, because chances are the vol crush has caught you by surprise at least once.
A vol crush is a sudden drop in implied volatility (IV) that often happens after a significant event such as an earnings report, regulatory decision, or clinical trial outcome. And when it happens, it can bring down the value of an option quite a bit. Why?
An option has both intrinsic and extrinsic value, with the extrinsic value representing risk premium. Let’s focus on earnings as an example. As an earnings date approaches, there’s a lot of uncertainty about how much a stock’s price could move. This causes the extrinsic value of the option to rise, which often leads to higher IV and increased options premiums.
The stock’s expected price move is already priced in to the options. But after earnings are released, there’s no more earnings “uncertainty.” That component, which was priced in to the option, has fallen to zero, which is why we often see IV drop rapidly after earnings reports.
Remember IV is an approximation of how much a stock’s price is likely to change. So, if IV is high prior to earnings, it means the options on the stock will be relatively more expensive. If you buy options prior to earnings and the earnings results don’t do much to the stock price, IV may still see a significant drop. This could bring down the price of the options, and you could end up losing money on your positions.
What if the stock price moves a lot after earnings? In that case, the drop in IV may not matter much, especially in options expiring soon after earnings. There’s little extrinsic value, and depending on which way it goes, you could make or lose money.
Although it’s possible to make profitable short-term trades that take advantage of vol crush, it can be risky.
Options closest to expiration tend to be more sensitive. So, if you’re looking for less sensitivity, you might consider options that expire further out because a vol crush may not impact them as much. But vega could be greater, all else equal, so you may see a larger value loss. Another workaround may be to compare IV to historical volatility. If IV is extremely high, you may want to wait until it falls closer to normal. And if you notice that IV is high, do your homework. It’s probably high for a reason.