The term ‘volatility crush’ is music to the ears of option sellers while option buyers likely relate it to the sound of nails on a chalkboard. This term refers to the sometimes massive decline seen in implied volatility levels of options. While a vol crush can mean losses for the option buyer, the opposite may be true for option sellers. In fact, selling options with significantly overinflated premiums can potentially be very profitable, although one must be willing to assume the risks that come with selling options. Depending on how options are sold, these risks can be unlimited.
How to potentially take advantage of a volatility crush:
Investor Bob has been watching options on stock ABC for a few weeks. ABC has an upcoming earnings announcement and implied volatility (IV) levels have been rising. In fact, IV has risen from 12 percent to 18 percent in just the last several trading sessions.
ABC is currently trading at $50 per share, and Bob believes the upcoming earnings announcement will be a non-event. Bob decides to try to take advantage of potentially overinflated option premiums by selling an iron condor. Bob initiates this position by doing the following:
- Sell the back month $55/$60 call spread for a net premium of $1
- Sell the back month $45/$40 put spread for a net premium of $1
Bob has collected a net $2 premium and stands to potentially profit if the stock price is between the short strikes of $45 and $55 at expiration. Bob’s maximum exposure on this trade is the $5 difference between strikes minus the $2 premium collected. Therefore, his maximum loss potential is $3.
With IV significantly elevated, Bob now sits back and waits for the earnings announcement to be released.
The earnings announcement is released and is right at consensus estimates. After an initial reaction, the stock price doesn’t move much at all and the announcement has proven to be essentially a non-event as Bob had anticipated.
Now that the uncertainty surrounding the announcement has been removed, IV levels in the options begin to contract rapidly, going from 18 percent down to 10 percent. As IV declines, so do the option premiums. The iron condor Bob sold for a net premium of $2 is now only worth $.40. Bob has just taken advantage of a volatility crush.
There are several things to look for when trying to identify candidates for a potential vol crush trade. Some key things to consider are:
- IV levels compared to their 12-month average.
- Key support and resistance levels.
- Volume and liquidity
- Time until expiration.
The vol crush can be great for option sellers and can potentially produce rapid profits. These strategies also carry significant risks that must be considered. The shorting of naked options, for example, carries unlimited risk and is not suitable for all investors. Even with defined risk positions such as the iron condor, things can and do go wrong and risk management should always be priority #1.