IVolatility crush occurs when the implied volatility (IV) of an option falls sharply, causing the price of the option to decrease. This usually happens after an anticipated event, like earnings reports, news releases, or other market-moving events. Before such events, there’s often increased demand for options, driving up their prices due to heightened uncertainty. However, once the event passes and the uncertainty fades, implied volatility drops, and the option premiums lose value rapidly. Traders who are holding long options may face significant losses due to this sharp decline in price.

Why Does Volatility Crush Happen?

Volatility crush is a common phenomenon that happens when markets expect significant moves due to upcoming events, such as earnings reports or product launches. Traders buy options in anticipation of large price movements, causing implied volatility to rise. As a result, option prices increase. However, once the event passes and the market has a clear direction, the uncertainty diminishes, and implied volatility falls back to normal levels, leading to a sharp drop in the price of the options. This sudden decrease in option value is referred to as a volatility crush.

How Does Volatility Crush Impact Options Traders?

Volatility crush impacts options traders who hold long options positions, especially those who buy calls or puts before an event. If you purchase options expecting large price movements and implied volatility rises, you may see the price of your options increase. However, once the event is over, and the volatility crush happens, the price of your options can drop sharply, causing losses. This is why it is essential for traders to understand the timing of volatility crush and plan their trades accordingly. Traders who sell options may benefit from volatility crush because they can sell options at inflated prices before the event, and then buy them back cheaper after the event.

How Can You Avoid Volatility Crush?

To avoid the risks of a volatility crush, traders should carefully consider the timing of their options trades. Some tips to avoid volatility crush include:

• Sell options before major events: If you are holding options, especially long options, you may want to sell them before the event to lock in any gains from the increased volatility.
• Use short positions for volatility trades: Instead of buying options before an event, you can sell options to benefit from the high implied volatility before the event and buy them back after the event when volatility drops.
• Use spreads: Another way to reduce the impact of volatility crush is by using options spreads, such as a straddle or strangle, which can help limit your losses while still allowing you to profit from volatility moves.

Real-Life Examples of Volatility Crush

An example of volatility crush can be seen after a company's earnings report. Prior to the earnings announcement, options prices are generally higher due to uncertainty about whether the company will meet expectations. Once the earnings report is out and the uncertainty is cleared, the implied volatility drops, causing option prices to fall sharply. A trader who bought options expecting big moves might see their position lose significant value, even if the stock’s price doesn't move much. This is an example of a volatility crush in action.