IV Crush Guide with Implied Volatility and Theta Decay

IV Crush Guide with Implied Volatility and Theta Decay

<        MAIN MENU        >

What is IV Crush and How the Top 1% Avoid It

IV Crush – An Introduction

Millions of new investors have discovered the power of buying options. However, many get a rude awakening when they get the direction of the stock price correct yet lose money on their options. This is caused, in part, by a phenomenon called IV crush. In this article, you’ll learn how the IV Crush happens, why it happens, and how you can avoid it. You'll also learn about implied volatility and theta decay, two concepts that play a large role in IV crush. But more importantly, the discussion of IV Crush raises a more serious question – Are you buying options the right way?

What is Implied Volatility?

Before we understand IV Crush, we must learn a few things about Implied Volatility, or IV.

First and foremost, Implied Volatility is just a number that gets spit out of a formula. That formula happens to be the same one that calculates the option greeks, the Black-Scholes formula. It’s not a pretty formula so I will spare you the details. Just assume it’s a black box.

Implied Volatility comes from the Black-Scholes Formula

Now, if you give the black box a Stock Price, an Option Strike Price, the Options Premium, an Expiration Date, an Interest Rate, and a Dividend yield, then the black box returns you some percentage number. This number is called the “Implied Volatility.”

I like to say, “It’s the Volatility implied by the Black-Scholes formula.”

Where do you find Implied Volatility?

The percentage number given to us by the Black-Scholes formula can be found on some Options Chains. For example, this options chain shows the Implied Volatility next to the Call and Put options premiums (see light blue outlines). More specifically, it shows the “Bid IV” and the “Ask IV.” 

Implied Volatility on the Options Chain

To get the Bid IV, you would include the “Bid” Option Premium into the black box. For the Ask IV, you would include the “Ask” Options Premium.

What does Implied Volatility Mean?

In options, the term “Volatility” refers to a standard deviation in stock prices. Now without getting too technical, a standard deviation simply helps you better understand a range of possible outcomes and it also helps you compare different situations. 

Specifically, the Implied Volatility refers to the % range above and below the stock price where the market anticipates that 68% of the time the stock will land between that range at the end of 1 year.  

Example: AAPL Implied Volatility

Let’s look at AAPL stock at $146.06. 

Assume that AAPL stock options have an Implied Volatility of 26%.

This means that 68% of the time, AAPL stock is expected to land between $108.08 and $184.03 in one year. Each of those two endpoints are 26% higher and lower from today’s AAPL stock price.

AAPL Chart with Implied Volatility 26 Range

If AAPL’s potential to keep making huge profits becomes more uncertain, then the expected range may increase along with the Implied Volatility. This would change the way it looks on the chart. For example, 35% IV would look like this:

AAPL Chart with Implied Volatility 35 Range

A decrease in Implied Volatility will narrow that range. For example, 20% IV would look like this:

AAPL Chart with Implied Volatility 20 Range

Implied Volatility & Options Premiums

The movement of this expected range has a direct relationship with the option premiums. 

As you might imagine, increases in Implied Volatility will increase the option premiums. Vice versa, decreases in Implied Volatility will decrease option premiums.

Direct relationship between Implied Volatility and Option Premiums

Investors view Implied Volatility as a measure of risk or uncertainty, which is reflected in the option premiums.

How do you use Implied Volatility?

Implied Volatility is often used by Volatility Traders to determine the relative value of an option, or how “cheap” it is. The Volatility Trader uses a combination of historical data and forecasted data to come up with an answer. 

This process used by Volatility Traders to determine “cheap” options is at the heart of the industry’s educational process. And unfortunately, that’s the big problem. The industry imposes this thinking upfront before you can even ask the question: “Am I a Volatility Trader?”

I assure you that you’re not. In fact, less than 1% of options traders are “volatility traders.” 

We’ll get back to this question later.

What is Implied Volatility Crush?

Implied Volatility Crush, or IV Crush, is the phenomenon where the Implied Volatility of an option declines sharply, in turn, “crushing” the options premiums. This usually occurs after a scheduled event has passed, such as earnings, product announcements, or an FDA meeting.

The unknown information to be released on the event causes uncertainty or greater risk in the stock price, which causes the Implied Volatility to rise prior to the event. Once the event passes and the uncertainty in the situation diminishes, options premiums are quickly repriced lower to reflect the new environment.

What is Theta Decay?

To fully understand IV Crush before and after the event date, you must conceptually understand Theta Decay. 

Theta Decay simply means that an option will lose value each day during the life of the contract. 

For example, assume that ABC stock is $100, and you own the 2-month $100 Calls.

Theta Decay over 2 months

Today, those Calls are worth $4.00.

Assume that the stock doesn’t move for 2 months, and we are on the last day prior to expiration without any scheduled event. Those calls might be worth $0.40, or something close to $0.

Even though the stock is at the same place, the option is worth a lot less because it no longer has the same potential range as it did 2 months earlier.

Theta Decay without an Event

Let’s visualize the path of an option’s premium one week prior to expiration. Note that these premium values are not exact and used only to highlight the important points I’m trying to make. Focus more on the concepts.

Theta Decay without Earnings

This chart shows you the options premiums of a normal Call Option 5 days prior to the Options Expiration. No major event is scheduled during this week. We assume that the underlying stock price does not move to isolate the Theta Decay.

Notice that the value of the option decreases each day. On Monday, the option starts at $2 before losing some value each day. At the end of the day on Friday or Expiration, the option will be worth $0 if the stock ends at or below $100.

Now, consider what the chart might look like if the stock has a scheduled earnings report on Thursday evening.

IV Crush after earnings?

Using our example, this is what the value of the option might look like each day if there was a scheduled earnings announcement on Thursday evening. Again, we assume that the stock price remains at $100 after the earnings announcement to isolate the Theta Decay

IV Crush after Earnings

Here we have an option that starts at $2 on Monday; however, it doesn’t trade lower like the option without an earnings announcement. In fact, there seems to be no Theta Decay until after the earnings announcement on Thursday. 

After Thursday’s earnings announcement, the option premium declines substantially from $2.00 to $0.20 on Friday. This is the IV Crush in action.

Now, let me add back the chart without earnings and highlight the difference. 

Theta Decay and the IV Crush

Notice how the option starts and ends at the same level on Monday and Friday (green bars). However, in between you can see a clear difference between the two charts (darker green bars).

It’s important to understand what’s happening there.

Why does IV Crush happen? 

If we look at the expiration chart without an earnings event and add in IV numbers, you will notice something interesting.

Theta Decay with the same Implied Volatility

On Monday, we start with $2 in premium and an IV of 25%. Each day, the option premium and the days left to expiration change. When given to the Black-Scholes formula, or the black box, it returns an IV of 25%.

Implied Volatility Before Earnings

On the other hand, when there’s an announcement that could potentially cause a significant move in the stock price, the demand for options tends to increase as buyers try to profit from such a move.

In our example, buyers are willing to pay $2 in front of the earnings because they think they could make significant profits after earnings are announced.

Theta Decay with different Implied Volatility

Like the chart without earnings, the $2 option premium on Monday returns us an IV of 25%. 

However, if we throw in $2 again on the next day. The Black-Scholes formula gives us a new Implied Volatility number. But this time that Implied Volatility number is different because we have 1 day less time to expiration. In our example, notice that Tuesday’s IV is 29% which is higher than Monday’s 25%. 

This increasing IV continues for the next few days. The Black-Scholes formula receives an options premium holding at $2 with time decreasing. This cause the formula to return a higher IV.  

While the market is taking out Theta, it is accounting for the potential volatility that might happen due to the earnings announcement.

On the face of it, we just see an option that is holding its value ($2) where it otherwise wouldn’t during a normal expiration week.

Assuming that the announcement has no effect on the stock price, the option goes back to its “normal” volatility state (i.e. 25% IV) and the option premium reinstates itself into its “normal” trajectory $0.20. 

How do you value the IV Crush?

IV Crush is not responsible for the whole decline between Thursday and Friday. The option would have experienced some Theta Decay as shown in the scenario without earnings.

So, the total decline in option premium from Thursday to Friday was $1.80. Thursday’s premium went from $2.00 to $0.20 on Friday. 

The IV declined from 43% to 25%. This is the IV Crush.

To calculate the IV Crush in dollars, you should take out the Theta from the “normal” period without earnings. Theta Decay from Thursday to Friday during a normal expiration is $0.65. Therefore, $1.80 (total decline) less the $0.65 (due to Theta) equals $1.15 assigned to the IV Crush. 

Opportunity to Sell Options? 

After seeing this and perhaps hearing others describe IV Crush, the initial inclination most investors have is to sell options ahead of earnings to profit from the IV Crush. 

Not so fast. 

In our example, we assumed that the earnings announcement didn’t cause ABC stock to move. Obviously, that’s not what happens in real life.

Stocks do move and sometimes they move a lot.

Example: Selling Options and IV Crush

If ABC stock jumps $20 on earnings, then the option premium will increase to about $20. 

How to Buy Options to Avoid IV Crush

So, you would have profited from the IV Crush when the implied volatility declined from 43% to 25%, but you would have lost $18 ($20 ending value - $2 premium) on the trade. 

Notice that the profits from the IV Crush were relatively tiny in the big picture.

This example should help you realize that at some stock price level, the IV won’t matter.

The Give and Take of Options

While most online gurus use the IV Crush phenomenon as a reason to sell options, it’s missing the most important point. 

Options offer the buyer enormous leverage, the ability to turn $1 into $3, 4, 5 or more than $10.

You don’t get to buy leverage in front of a significant announcement like earnings for the same price that you would pay on a normal week without earnings.

This is the price you pay for that opportunity.

And for sellers, you receive the option premium upfront because you assume the risk of a potentially outsized move in the stock price.

That is the natural give and take offered with options. 

How do the Top 1% think about IV Crush?

At OptionsGeek, you learn how the Top 1% think about options, specifically, how they buy options. And while the Top 1% clearly understand the IV Crush phenomenon, most of them don’t spend too much time stressing about it.

They focus more on the Target Stock Price that may be hit after the earnings announcement, and then analyze the different option strikes to determine if they see an opportunity.

The Top 1% know that if they can get the Target Stock Price right AND choose the right option, the IV Crush won’t matter. 

For example, let’s assume you think that the stock will increase from $100 to $104 and you buy the $2.00 Calls on Monday.

How to Buy Options to Avoid Implied Volatility Crush

If the stock reaches $104 on the earnings announcement, then the option will trade at approximately $4.00 on Friday. 

While this trade would be profitable, you must determine whether buying the $100 Call option for $2 on Monday is the best choice. You also must be able to prove it.

The Top 1% know that answer. It’s how they shift the odds in their favor.

How to Avoid IV Crush

To be successful at buying options you need to know how to buy options to gain an advantage. This means you must fully understand what negatively affects the value of your option so you could learn to avoid it. 

IV Crush is one factor that negatively affects the option premiums.

To avoid IV Crush, you must learn how to choose the right option that offers you the best risk-reward on your Target Stock price. Which leads to your next dilemma:

“How do I choose the right option to buy?”

This is the most important question in options. 

Unfortunately, the available education doesn't teach you the answer. And I haven’t seen any online Option “guru” that could explain the answer.

If you don’t believe me, watch this next video that shows you proof that even the professionals don’t know how to choose the right option. It will even show you all the fake answers given by online options “gurus.”

Then just go ask any options “guru” that question to see what they say.

In a nutshell, you can avoid IV Crush by learning how to buy options like the Top 1%. I built OptionsGeek to answer that question and close the knowledge gap between you and the top investors in the world.

Finding Opportunity with IV Crush

IV Crush can offer a profitable opportunity for those investors willing to better understand options at a higher level.

In fact, there are several elite hedge funds that use a few options strategies to take advantage of stock price direction AND the IV Crush at the same time. But that takes more experience and a very strong Options foundation.

So, if you want to build a strong foundation and learn how to buy options like the Top 1% then learn more about 3 Steps to Profit. It’s my groundbreaking Options Trading Course that contains new information with new concepts and a patented Options Chain that is truly a gamechanger. 

3 Steps to Profit shows you a process to find the best trade ideas that target 150-400% returns and an options plan to extract those profits.

Learn More About Coaching







winning picks full book cover



Click to Join the Options Trading Newsletter



Learn More about the Best Options Trading Course


OptionsGeek 3 Steps to Profit Video Explainer