The Crush Is Real
A trader was right. The stock went up. And somehow, the trader still lost money.
Introducing volatility crush — one of the most puzzling and misjudged aspects in options trading.
Most beginners think of an option as a simple directional play. Buy a call, stock goes up, and you make money. Buy a put, stock goes down, you profit. Clean and simple. But options are not that simple. Every option price is driven by distinct factors that operate simultaneously: Two of these factors are direction and implied volatility. While direction gets all the attention, it is only half the equation. Implied volatility is the other, and often it requires a more nuanced understanding.
Think of implied volatility as the cost of uncertainty, that uncertainty is baked into the price of the option. This is especially significant when anticipating a future event, like earnings.
An earnings announcement is one of the biggest scheduled uncertainty events for stocks. Nobody knows if the company will beat or miss earnings. Nobody knows what guidance management will give. Nobody knows how the market will react. That uncertainty drives the price of the option and the moment that uncertainty is replaced with more certainty, options tend to reprice quickly — and the right direction may not overcome the changes in premium. This phenomenon is generally referred to as “volatility crush.”
In the weeks leading up to an earnings announcement implied volatility (IV) typically increases steadily, inflating option prices in anticipation of the unknown impact of the announcement on the stock price.
Now, imagine a trader buys a call option on a stock the day before the earnings announcement, expecting the stock to rally on a good report. The stock is trading $100 and the $105 call option is purchased for $2.90.
The next day, the earnings announcement arrives and the stock rises to $106 and those call options are somehow worth $2.10, which is less than what the trader paid.
What happened? Implied volatility before the announcement was at 80%. After the announcement, with the uncertainty resolved, implied volatility dropped to 30%. In this case, the reduced option premium stems from the drop in Implied Volatility, which diminished the impact of the upward move in the stock price.
So how do you determine if you’re buying cheap or pricey options? A raw implied volatility number like 80% means nothing without context. One way to gain perspective on what that Implied Volatility number might mean is to look at where it sits relative to its own history.
IV Rank and IV Percentile answer those questions by placing todays IV in historical context. These tools measure where current implied volatility sits relative to its range over time.
For simplicity, IV rank places the current implied volatility on a scale of zero to 100, if IV rank is zero it means IV is at its lowest point over the past year. Options are as low as they have been in twelve months. If IV has a rank of 100 it’s at its peak, over the same timeframe. Options are as costly as they have been in the past year. A rank of 50 means IV sits exactly in the middle of its annual range.
IV Percentile tells you where the current implied volatility sits relative to its own history over a given period. If IV Percentile is at 72%, it means implied volatility has been lower than its current level of 72% of the time and higher 28% of the time, suggesting options are relatively high, historically.
Neither metric predicts direction, but they help traders avoid a common mistake: trading options implied volatility levels without a historical context – which may lead to buying options that might underperform during a move, or selling options that might outperform their implied volatility levels during that same move
Volatility crush isn’t a flaw in the options market — it’s the market doing its job and is a natural part of supply and demand. Options are priced to reflect expectations and uncertainty. Once an event comes and goes, uncertainty is generally replaced with more certainty, and that is accompanied by a commensurate repricing of options.