Don’t Get Crushed by Earnings: Be Aware of a Volatility Crush

Volatility can be like your breath. A big inhale can be thought of as rising realized volatility or implied volatility (IV), and a big exhale can be viewed as falling realized volatility or IV.

You may be wondering why IV sometimes rises and falls more than at other times. Let’s unpack it a bit.

Realized volatility is simply a measurement of how much a stock swings—up or down over a given time period—and expressed as a percentage. IV is the options market’s way of making an educated guess on the amount of future volatility in the underlying and pricing that volatility risk into the options. Remember: The larger the implied volatility reading, the more expensive the options prices.

The Quarterly Earnings Dance

When companies release their quarterly earnings reports, an interesting scenario plays out in the stock market. Earnings announcements are a binary event—the price action outcome is a coin toss. As an earnings announcement approaches, options reflect potential or anticipated moves in the underlying stock. Options IV levels typically rise going into an announcement and reflect what traders are willing to pay for calls and puts at that time. Think of this as the big inhale. Order flow and market maker algorithms help establish and adjust IV levels before and after earnings are announced. 

As you can imagine, after the earnings release when the updated fundamentals are known, all that IV priced into the options usually deflates. That’s the big exhale and is often referred to as a volatility or IV crush. And if you want to trade options around earnings, it’s important to understand IV crush.

You may be right on the direction of the stock after an earnings report, but if you bought the call or put option at inflated IV levels prior to the report, the volatility crush afterward may push that option into a losing position. That could be an unpleasant surprise.

Build Intelligence into Trading Around Earnings

One of the most important questions to ask yourself is whether you should trade around earnings at all. Only you can answer that question. Perhaps you have considerable unrealized gains in a stock and really don’t want to sell for several reasons, but you’d like to potentially find a way to protect your downside through the earnings release. You can potentially buy an out-of-the-money put to protect your downside and perhaps sell an upside call against the stock to finance the put option. This will cap the upside but will probably help you sleep better at night.

Although nothing is 100% certain, there is a relatively high probability that the IV in those options is going to get crushed as soon as the earnings report is released. Knowing that, how would you play an IV crush?

Be Prepared by Analyzing Ahead of Earnings

First, analyze the market’s expectation of the magnitude of the earnings move. Remember we talked about market makers pricing volatility risk into the options prior to the earnings report? Here’s how you can find the expected move.

Fire up the thinkorswim® platform, select the Analyze tab, enter a symbol, and expand the Option Chain (see figure 1). On the right of each one, you’ll see the expected move. The option chain that corresponds with the one expiring the week of an earnings release will typically be higher as you get closer to the earnings date.

Another way is to look at the Market Maker Move (MMM), which you’ll see displayed on the symbol bar (the yellow MMM). This will typically appear during earnings week, but can appear any time the nearest expiration has IV higher than further out expirations.

There are other ways to analyze volatility. You could look at Today’s Options Statistics below the Option Chain. Here you’ll find the Current IV Percentile, which is something you’ll want to keep an eye on as a company’s earnings approaches. You can also see how a stock did compared to its IV in past earnings periods. Select the Earnings subtab to see a graphical representation of IV performance during past quarters.

Options Strategies for Volatility

There are a number of short volatility strategies to consider when looking at earnings plays. Say the market is pricing in a max implied 7% move. You could sell an iron condor outside this band to potentially profit on the volatility crush after earnings if the pricing makes sense from a risk/reward standpoint.

What strategy you want to use is really a personal choice. As with any market engagement, whether around earnings or otherwise, the most important aspect to consider is risk management. If you can’t quantify the risk, it may be better to step aside and not play at all.