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What is "IV Crush" in Options Trading?
Before and after the release of financial reports, implied volatility (IV) often experiences a sharp decline, a phenomenon referred to as IV Crush.
This article is divided into three parts: one, introducing the concepts of IV and IV Crush; two, sharing option trading strategies related to IV Crush; three, discussing my own views on NVIDIA.
I. Concepts of IV and IV Crush
What is IV?
What is IV?
IV, or Implied Volatility, is a critical parameter in option pricing models, representing the market's expectation of future volatility in the underlying asset. Unlike historical price data, IV is inferred from option market prices. Therefore, IV reflects current market conditions and participants' expectations, providing valuable insights into market volatility.
High IV indicates a market expectation of significant future price fluctuations, implying higher risk and uncertainty, while low IV suggests a market expectation of smaller price fluctuations, indicating relative stability.
What determines the level of IV?
Market sentiment and supply-demand dynamics: Increased demand for options leads to higher option prices, resulting in an increase in IV. Conversely, if the market anticipates smaller price fluctuations, option demand and prices may decrease, leading to a decrease in IV.
Price fluctuations of the underlying asset: Although IV is primarily derived from option prices, actual price fluctuations of the underlying asset will affect the future value of options. In simple terms, all else being equal, the higher the stock price, the higher the corresponding option price and IV.
Major events: Significant events such as financial report releases or policy changes may cause substantial price fluctuations in the underlying asset. Before these events occur, market uncertainty increases, leading to increased option demand, which in turn drives up option prices and IV.
How does IV affect option pricing?
In simple terms, option prices are positively correlated with IV. High volatility implies a wider range of price movements for the underlying asset in the future, increasing the likelihood of options being profitable at expiration.
Although selling options may seem more attractive to option sellers when IV is high because of the higher option premium, this also comes with higher risk. If actual volatility exceeds market expectations, sellers may face significant losses.
What is IV Crush during earnings seasons?
IV Crush during earnings seasons refers to the phenomenon of a rapid decline in implied volatility (IV) before and after the release of financial reports.
Before the release of financial reports, IV usually increases due to increased uncertainty. Once the financial reports are released, IV rapidly decreases, eliminating uncertainty.
From the perspective of IV levels alone, this benefits sellers, as they can sell options when IV is high and buy them back when volatility decreases. Buyers, on the other hand, may face a sharp decrease in option value.
II. Option Strategies Related to IV Crush
There are many option strategies, ranging from single-leg trades to combinations such as long call/put and short call/put.
There are many option strategies, ranging from single-leg trades to combinations such as long call/put and short call/put.
Given the upcoming NVIDIA earnings report and considering the length of this article, I will discuss one strategy related to IV Crush for both option buyers and sellers.
Option Buyer Perspective: Betting on Unilateral Upside Potential with Near-Term Options
As mentioned earlier, option prices are positively correlated with IV. IV Crush causes a sharp decline in option prices, which is generally unfavorable for buyers.
As mentioned earlier, option prices are positively correlated with IV. IV Crush causes a sharp decline in option prices, which is generally unfavorable for buyers.
However, why do some near-term options sometimes generate substantial profits? The reasons are as follows:
Directional bet: Correctly predicting the direction of the underlying asset's price movement, and if this movement is significant enough to exceed the negative impact of IV Crush on option value.
High leverage: Near-term options typically have lower prices, providing higher leverage.
While the objective of betting on unilateral upside potential with near-term options seems promising, investors should consider the risk-reward ratio given the rapid time decay of these options. Even if the stock price moves in the right direction, "time decay" can erode the intrinsic value of the option's profit.
Given the high cost of opening NVIDIA options positions and the risk of zeroing out, investors should consider the risk-reward ratio when betting on doubling their investment.
Option Seller Perspective: Shorting IV
The strategy of profiting from IV Crush during earnings seasons essentially involves selling options to collect premiums. As implied volatility decreases, so does the value of the option.
The simplest strategy is to sell naked calls and naked puts, representing a view of not expecting an increase or decrease in the price of a particular stock. I believe this is a strategy to avoid directional bets affected by "time decay." However, this also limits profit potential and requires margin.
If you aim to profit from both upward and downward movements in stock prices by collecting premiums from both sides, rather than betting on specific price directions, you can use a strategy called "Straddle Sell": simultaneously selling an equal number of call and put options with the same expiration date and strike price.
Straddle Sell Example Using NVIDIA as of February 21, 2023, Pre-market, with the current stock price of $694:
Detailed Procedure:
Set Parameters
Strike Price: $695
Expiration Date: February 23, 2023
Execute Trades
Sell call and put options with a strike price of $695, collecting premiums from this operation, marked as maximum potential profit.
Set Profit-taking Range
Profit-taking Range: $619 to $770
Once the stock price touches the boundary of this range, consider closing out the options by buying them back to lock in profits or reduce losses.
Closing Operation
If implied volatility decreases as expected and the stock price remains within the profit-taking range of $619 to $770, consider closing out the options by buying them back at a lower price to realize profits.
Although the example illustrates the Straddle Sell strategy using NVIDIA $NVIDIA (NVDA.US)$ as an example, simultaneously selling call and put options to collect premiums, it is not recommended to implement this strategy for highly volatile stocks such as NVIDIA! As mentioned earlier, market-traded expected volatility is already high! The high volatility of NVIDIA increases the risk of the strategy, and in the event of a black swan event, it may result in significant losses (buying assets at non-target prices or forced liquidation due to insufficient margin).
III. My Views on NVIDIA During Earnings Seasons
Summarizing the content: Identifying the abnormally high volatility of NVIDIA—Introducing what IV Crush is through financial reports—Analyzing option strategies related to IV Crush.
NVIDIA, as a star stock, has received numerous opinions from the market. I am not lacking in providing my own judgment on its direction.
In addition, as a newcomer to the stock market, NVIDIA's volatility makes me adopt a cautious attitude. I don't understand it, and I can't read it— I neither have enough confidence to participate nor have a clear bearish rationale.
I have recently been brushing up on my knowledge of options, so I am sharing my learning and thoughts for discussion with fellow investors.
Disclaimer: Community is offered by Moomoo Technologies Inc. and is for educational purposes only.
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