What is an Implied Volatility (IV) Crush and How to Avoid it

In the options universe, “implied volatility crush” (aka volatility crush) refers to a significant decrease in the implied volatility of a particular option, or a group of options. Implied volatility (aka IV) is a measure of the market's expectation of future volatility, which is a critical component in the determination of options prices. 

When a volatility crush occurs, that means the implied volatility of an options contract (or group of options contracts) drops abruptly. This usually occurs after a significant event passes, such as an earnings announcement, or a highly anticipated news release. 

Implied volatility can spike for a wide range of reasons, and anytime this occurs, there’s a chance that implied volatility could abruptly crater, resulting in a volatility crush. As such, investors and traders active in the options markets must be constantly vigilant of the risks associated with a potential volatility crush, and manage accordingly. 

Overall, an understanding of implied volatility, and its typical behavior, is extremely important for participants in the options market. In this regard, the potential for a volatility crush is only one facet of options trading. Market participants electing to trade options must therefore consider not only the potential for a volatility crush, but also the full range of potential outcomes. This helps ensure that the trader in question understands the key risks and rewards associated with a given position.

Implied volatility can spike for a wide range of reasons. And anytime implied volatility spikes, there’s theoretically a chance that it could abruptly crater, resulting in a volatility crush. As such, investors and traders active in the options markets should be constantly vigilant of the risks associated with a potential volatility crush, and manage that risk accordingly. 

Along those lines, there are certain categories of events that may be characterized by a sharp spike in volatility, and an ensuing volatility crush. More details on these types of events are outlined below:

• Earnings Announcements: Leading up to an earnings announcement, options prices often rise due to increased uncertainty about the stock's future price movement. After the earnings release, uncertainty typically dissipates, triggering a decline in implied volatility and, consequently, a volatility crush.

• Mergers and Acquisitions: When there's speculation over a potential merger or acquisition, implied volatility may rise as market participants position to capitalize on a potential move in the underlying shares of the affected companies. Once the details of the deal are announced, or the event passes, uncertainty usually dissipates, leading to a sharp drop (aka crush) in implied volatility.

• Product Launches or FDA Approvals: In sectors such as biotech or pharmaceuticals, implied volatility can surge as investors speculate on the outcome of a product launch or an FDA approval decision. After the event occurs, and the uncertainty is resolved, implied volatility often drops, causing a volatility crush.

• Market Events or Economic Data Releases: Major economic events such as GDP reports, unemployment figures, or central bank announcements can lead to increased volatility in the broader market. Implied volatility may rise ahead of these events market participants deploy positions to potentially capitalize on the event. Once the data or announcement is released and absorbed by the market, volatility often declines, resulting in a crush.

• Expiration: Implied volatility may also decrease as options approach their expiration date, especially if there are no significant impending events or catalysts. This is because as options approach expiration, they have less time value, which often results in a decline in implied volatility.

• Resolution of Political Uncertainty or Geopolitical Events: Political events or geopolitical tensions can lead to increased volatility in the markets. When these uncertainties are resolved or tensions ease, implied volatility tends to drop. The passing of a key geopolitical event,  or the resolution of an important geopolitical conflict, may therefore result in a volatility crush. 

Overall, volatility crushes typically occur after periods of heightened uncertainty or speculation, and they often coincide with the resolution of events, or the passage of significant events/milestones. Market participants who understand these dynamics can potentially capitalize on them by strategically timing their trades. 

Theoretically, an options crush can impact a single option, or it can impact a group of options. Some hypothetical examples of earnings crushes are outlined below. 

Imagine, for example, that hypothetical stock XYZ has earnings in mid-September. Leading up to an earnings event, the implied volatility of the expiration month that captures the earnings event usually experiences a spike in implied volatility. In this example, that would be the monthly options for September, as well as any weekly options that capture the event. In the wake of earnings, the implied volatility of those options often drop back to “normal” levels, or even lower. That abrupt decline in implied volatility represents the post-earnings IV crush. 

Looking at another hypothetical example, imagine that new legislation has been proposed that would drastically reduce the profitability of the biotech sector. 

In this case, the implied volatility of options exposed to the biotech sector (stocks and ETFs) would likely rise. Especially for those options that specifically capture the event. For example, if Congress was scheduled to vote on the legislation in early February, this hypothetical scenario would likely push up the implied volatility of the sector for monthly and weekly options that encompass the vote. And for these options, volatility would almost certainly decline in the wake of the event, much like after a company report’s earnings. 

To track implied volatility, and potential volatility spikes and ensuing crushes, investors and traders can use metrics like Implied Volatility Rank (aka IV Rank). IV Rank reports the current level of implied volatility in a given underlying (stock or ETF) against the last 52 weeks of data.

As a result, IV Rank allows investors and traders to quickly filter for opportunities where implied volatility is trading at an extreme. For example, the upper or lower end of the 52-week range. Options traders prefer to trade volatility at extremes because volatility is historically mean-reverting. 

In terms of interpreting IV Rank, this metric is expressed as a value between 0 and 100%. For example, if implied volatility in hypothetical stock XYZ is trading at 50, and the 52-week range in implied volatility is between 25 and 75, that would indicate an IV Rank of 50%. 

On the other hand, if implied volatility was trading at 25 in hypothetical stock XYZ, then IV Rank would be 0%, because 25 represents the lowest level of implied volatility observed over the last 52 weeks. Alternatively, if implied volatility was trading at 75, that would represent an IV Rank of 100%, because 75 represents the highest level of implied volatility observed over the last 52 weeks.

When IV Rank is above 50%, options traders typically look for opportunities to sell volatility. This is especially true when the VIX is trading at elevated levels. The long-term average in the VIX is roughly 19. 

So when the VIX starts trending into the 20s and 30s, options traders usually get more active selling derivatives. On the flip side, volatility-focused traders tend to look for buying opportunities when the VIX - and IV Ranks - are depressed. This may be represented by a depressed IV Rank, or a low absolute value in the VIX. 

One thing options traders have to keep in mind, however, is the existence of “time decay.” As time passes, options lose value, because they draw closer to expiration. And that natural headwind can work against options buyers. 

Risk management is key to successful options trading. In that regard, participants in the options market need to be constantly vigilant of all potential risks in their portfolio. The potential for a volatility crush is just one of many risks that an options trader must manage.

To avoid capital losses associated with a volatility crush, investors and traders should avoid buying options that have elevated levels of implied volatility. In cases where such options are purchased, the trader must actively manage the position, to ensure that the passing of a key event doesn’t result in a volatility crush, which could trigger a significant loss in the associated position.

That said, it’s not always advisable to sell options with inflated implied volatility, either. Because in some cases, there may be a reason for elevated volatility, due to a potential gap move in the underlying stock or ETF. Participants in the options market must therefore carefully study each opportunity, and ascertain whether it fits their outlook and risk profile. Just as they would analyze how a potential spike in volatility (the opposite of a volatility crush) might impact their potential position.

For these reasons, options trading usually involves extensive scenario analysis. This process helps the trader understand what scenarios produce a profit, and what scenarios produce a loss. Instances in which the investor/trader feels confident about a particular outcome tend to be among the most favored trading ideas. 

Like any position in the market, participants in the options market seek to structure positions that profit from the most likely outcome. This involves scanning the options market for potential opportunities, and then designing positions that will theoretically profit from the highest-likelihood scenario. When confidence is high in a particular outcome, that’s when an options trader usually pulls the trigger, and deploys his/her preferred position.

In terms of profiting from potential IV crushes, the process is much the same. For example, if an options trader believes that an earnings announcement is going to be a “non-event,” and that the underlying won’t move in the wake of earnings, he/she might deploy a short options position that benefits from a sharp drop in implied volatility after the earnings event. In this case, the big risk is that the underlying makes a gap move, and triggers a significant capital loss.  

Regardless of the opportunity in question, options market participants should closely analyze the worst case scenario associated with any potential position, and manage accordingly. In some cases, this may involve passing on an opportunity. In other cases, this may involve adding another dimension to the trade structure, which helps mitigate potential risks associated with the worst-case outcome. 

At the end of the day, profiting from a potential volatility crush is no different than any other options-focused opportunity in the market. It starts and ends with maximizing potential gains, and minimizing potential risks. This is done by pursuing high-confidence outcomes that match one’s outlook and risk profile. 

In the options universe, “implied volatility (IV) crush” (aka volatility crush) refers to a significant decrease in the implied volatility of a particular option, or a group of options. Implied volatility is a measure of the market's expectation of future volatility, which is a critical component in the determination of options prices. 

Implied volatility can spike for a wide range of reasons, and anytime this occurs, there’s a chance that implied volatility could abruptly crater, resulting in a volatility crush. As such, investors and traders active in the options markets must be constantly vigilant of the risks associated with a potential volatility crush, and manage accordingly. 

Events such as earnings announcements, mergers, and FDA decisions are often characterized by spikes in volatility, and ensuing volatility crushes. When a volatility crush occurs, that means the implied volatility of an options contract (or group of options contracts) drops abruptly. This usually occurs after a significant event passes, such as an earnings announcement or a highly anticipated news release. 

Leading up to significant events, heightened uncertainty can trigger increased demand for options, which is represented through elevated levels of implied volatility. However, once the event has passed, uncertainty tends to dissipate, which can lead to reduced demand for options, and a decline in implied volatility.

A volatility crush can have a significant impact on options prices. As such, market participants who have purchased options before an event in anticipation of a large price movement may find that even if the underlying asset moves in the expected direction, the decrease in implied volatility can cause the option prices to drop sharply in value, resulting in losses. 

Conversely, traders who have sold options prior to the event may benefit from the decrease in implied volatility, because that can cause the options they sold to decrease in value. On the other hand, short options positions can suffer dramatic losses amidst significant events, as well. Especially if there’s an unfavorable gap move in the underlying stock or ETF. 

Overall, an understanding of implied volatility, and its typical behavior, is extremely important for participants in the options market. In this regard, the potential for a volatility crush is only one facet of options trading. Market participants electing to trade options must therefore consider not only the potential for a volatility crush, but also the full range of potential outcomes. This helps ensure that the trader in question understands the key risks and rewards associated with a given position.