Volatility crush is a term used in options trading to describe the swift reduction in implied volatility of an option after the underlying stock’s earnings are announced or some other major news event.
A volatility crush occurs because the implied volatility of options will rise before an earnings announcement when the future price path of the stock is most uncertain, and then fall once the earnings are announced and the information .
What Is Implied Volatility?
Option prices are calculated using the current price of the stock, the strike price of the option, the length of time until the expiry date and the expected volatility in the stock’s price over that length of time.
The greater the price of an option relative to the difference between its strike price and the current price of the underlying stock, the greater the premium that is being demanded to account for the uncertainty surrounding the expected volatility of that stock.
Therefore, the premium that an option commands is a measure of the implied volatility that investors are expecting.
Volatility Crush and Trading
The price action in the options market surrounding a volatility crush represents a number of different opportunities to profit.
Option prices tend to rise heading into an earnings announcement, and the premiums, though not necessarily the overall price, will tend to fall as the actual volatility crush itself occurs following the earnings announcement.
It represents a period of high price volatility in the options market that is an ideal hunting ground for day traders of all sorts.
A volatility crush represents a predictable pattern of price movement in the options market that traders can use to their advantage.
Understanding the increasing rate of premiums before an earnings announcement followed by the likely decrease in implied volatility help traders make smarter, more informed decisions.