IV Crush options is a very important phenomenon in options trading. Options traders need to understand it better to avoid huge losses.
Are you among options traders who suffered significant losses because of IV Crush options? Then this guide is what you need to avoid. In today’s guide, we are going to explain IV Crush options, why, and how it happens. So let’s begin!
Learning a few things about implied volatility, in general, is crucial before understanding IV Crush options.
Implied volatility in options means, in the easiest terms, standard deviations in the prices of stocks. Technically, it is a percentage range below or above the stock price that the traders predict. Implied volatility is so effective that 68% of the time stock prices land within the anticipated range. History confirms this fact.
Furthermore, it helps options traders predict a range of possible outcomes. Additionally, it allows traders to compare different possible scenarios. So, how implied volatility percentage is calculated? It is calculated using a complex formula that you don’t need to understand. There are different factors that the implied volatility formula uses and gives us a percentage number. These factors include;
- Stock price
- Interest rate
- Dividend yield
- Option strike price
- Options premium
- Options expiry date
Now, how do options traders use implied volatility?
To determine the price of an option or calculate the relative value of an option. Yes, options traders use implied volatility percentage to calculate the relative value of an option or see how cheap an option contract is. These traders use both historical data and forecasted data to see the value of an option.
Another point to remember is that options traders consider two aspects when trading on options. Firstly, they keep one eye on the direction of stock price. Secondly, the other second eye on the implied volatility. Why implied volatility is important? Because it directly affects options premium. When implied volatility increases, options premium also increases. Whereas, its decline brings options premium down.
How does implied volatility affect options premium? It affects because of intrinsic and extrinsic values of options. As you know, intrinsic value and extrinsic value provide the foundations for the price of options. Therefore, when implied volatility increases, the extrinsic value of options also increases and vice versa.
IV Crush options
Implied Volatility Crush or IV Crush is a scenario whereby the implied volatility of options declines dramatically. As the name suggests, it crushes the options premium with quite a force. IV Crush options often occur after a significant event. For example, after earning an announcement or any other news event, the implied volatility of options may decrease sharply.
Simply put, unknown or insufficient information about an upcoming news event causes uncertainty among traders. As a result, stocks that come become risky and the implied volatility rises before the event. So, the options premium rises. However, once the situation becomes normal after the event, options premiums quickly decline to reflect the new conditions.
We if make it more simple, we can say that there are two situations. The situation before the event is uncertain because of unknown information. On the other hand, the situation after the event diminishes uncertainty because the information is now known. That means, moving from uncertainty to certainty makes options premium decline.
What is the effect of IV Crush options on options price?
Implied volatility is a major factor that determines the price of an option. There is a direct proportion between the two. If the implied volatility increases, the price of options also increases and vice versa. In fact, it is the open market that determines the price of an option. However, pricing models give us an implied volatility percentage that indicates uncertainty. In other words, it shows the market’s sentiment.
So, when uncertainty increases, the implied volatility also increases, and as a result, options prices also increase. That means options with expiry after the known event has high implied volatility. Options return to normal once the unknown becomes known.
Are IV Crush options beneficial or detrimental?
IV Crush options can be both beneficial and detrimental. It depends on whether you are buying options or selling options.
When buying options, high implied volatility leads you to pay a high options premium. Traders accept high premiums hoping for drastic changes in underlying stock prices. So, when buying call options, you pay high premiums in hopes of a substantial increase in stock prices. Whereas, when buying put options, you hope for a dramatic decline in stock prices. However, IV Crush options significantly affect options prices once the information becomes known.
Traders seek to collect high options premium when selling options. As you know, implied volatility directly affects the premium earned. So, high implied volatility means a golden opportunity to win high premiums when selling options. Therefore, traders sell options before an upcoming news event to earn high options premiums.
How to protect yourself against IV Crush options
IV Crush options negatively affect options prices and may cause huge losses. However, there are two simple ways to protect yourself from falling prey to IV Crush options.
The first way is simple – avoid trading options with an expiry date after an upcoming news event. For example, if the expiration month contains earning announcement, you should prefer not to trade that options contract.
The second way is to closely observe historical volatility. If implied volatility is higher as compared to prior periods, it is better not to trade.
IV Crush options is a situation that causes the extrinsic value of options decreases dramatically after a major news event. For example, corporate earnings announcement or any other such event increases uncertainty among options traders. However, when the uncertainty is diminished once the event is passed, the market gets back to normal.
In simple words, unknown or insufficient information about an upcoming news event means increased uncertainty among traders. This uncertain situation makes stocks that come riskier and the implied volatility rises before the event. As a result, the options premium also rises However, once the situation becomes normal after the event, options premiums quickly decline to reflect the new conditions. This sudden and drastic change in implied volatility crushes traders.
IV Crush options can be both beneficial and detrimental. It is beneficial for sellers while may prove detrimental for buyers. So, selling options is better when a news event is expected. Moreover, you can also prevent getting crushed by IV Crush options in two ways. Firstly, avoid trading options with an expiry date after an upcoming news event. Secondly, close observation of historical volatility also helps in preventing losses because of IV Crush options. If implied volatility is higher as compared to prior periods, it is better not to trade options.