Earning sessions give rise to some of the best trading opportunities as the volatility that comes into play triggers wild price swings. The kind of numbers on earnings and revenues that a company reports play a big part in whether a stock price will move up or down. Forecasts also influence trader’s sentiments, conversely influencing volatility levels.
Heading into stocks earnings sessions, traders look to take advantage of varying degrees of volatility that hit the market as well as stocks. The volatility crush strategy is one such strategy leveraged on stocks that experience low to moderate price moves heading into earnings announcements. The strategy's basic idea is to trade call and put options to take advantage of volatility changes after earnings announcements.
The uncertainty around earnings reports as speculation fills the air is one reason implied volatility tends to pick up heading into earnings announcements. Similarly, volatility tends to decline once the reports are out and on investors digesting the results. The significant decline in volatility after an earnings report is often referred to as implied volatility crush.
What is implied volatility?
Option prices are arrived at based on the underlying price of a stock. The strike price, which is the set option price, also influences price and the length of time to expiry. The greater the difference between the strike price and the stock's current price, the greater premium a trader is willing to pay to account for the uncertainty surrounding expected volatility.
Therefore, the premium that a trader is willing to pay on an option is the implied volatility. Implied volatility tends to rise significantly when investors are expecting bid announcements such as earnings announcements, FDA results on a drug, etc.; during this time, option buyers are the most aggressive in the market than sellers. The buying spree that comes into play results in higher implied volatility triggering a higher option premium.
Earnings Example
Consider stock XYZ priced at $100, two days to earnings. If one straddle can be bought or sold for $3 before the earnings report, it means the market is projecting a 3% move on earnings day. If the stock has a straddle price of $10, it means the market is projecting a 10% (10/100 X 100) price move on the earnings date.
Therefore, if a trader believes the 10% expected price move is a big premium to pay and that price is unlikely to move by such a margin, they could easily sell the straddle before earnings. The sell position taken will be a winner on stock price, failing to move by the 10% margin expected before the earnings.
How Implied Volatility Crush Strategy Works
Uncertainty often grips stock prices heading into earnings reports. Amid the cloud of uncertainty, demand for option contracts tends to increase. In return, an option's extrinsic value tends to increase, which often coincides with rising implied volatility.
Going into an earnings report, the market will often price a significant implied move in the asset price under study. As the earnings date approaches, the market will continue to price the options for an implied move.
Implied volatility on put and call options will often rise before an earnings announcement in response to uncertainty in the underlying stock price. As soon as the earnings report is out, the implied volatility will drop significantly, resulting in a crush.
Taking Advantage of Volatility Crush
While volatility crush can mean significant losses for an option buyer, it can also translate to significant profits for option sellers. Therefore, it is possible to profit when volatility crushes immediately after earnings.
Selling overinflated options premiums is one of the best ways to profit with the volatility crush strategy. However, one must also be ready to assume the risks that come with selling the options.
Example
Consider stock XYZ has been experiencing a spike in implied volatility heading into an upcoming earnings announcement. Over the last two weeks, its implied volatility has risen from 10% to 17%, with the stock trading at about $40 a share.
Jason, an investor, believes the earnings report will disappoint and will not strengthen the stock sentiments conversely fuel price bump. In this case, the investor decides to take advantage of overly inflated option premiums of stock XYZ in the options market.
The trader could initiate the following trades
- Sell the $45/$50 call spread at a premium of $1
- Sell the back month $35/$30 put spread for a net premium of $1
In this case, Jason will collect a net $2 premium and stand to profit on the stock price averaging between $35 and $45 at expiration. The trade's maximum exposure is the $5 difference between the strike price and the $2 premium collected.
While trying to profit from an implied volatility crush, it is important to pay close attention to
- The implied volatility levels compared to the 12-month average
- The key support and resistance levels
- Volume and liquidity
- Time until expiration
Bottom Line
Volume crush is a vital trading strategy for options traders as it produces rapid profits in times of uncertainty. However, the strategy also carries significant risks that one must consider. Selling options come with unlimited risks that one must always be ready to respond to.
Trying to profit from volatility crush is not a game for beginners. The strategy requires lots of experience as it can be a challenge to accurately predict stock price direction, let alone know how much the option price is likely to change.
