Volatility Basics

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Volatility Crush

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Implied volatility is one of the primary components that determines an option’s value. All other things being equal, higher implied volatility equals higher option prices, while lower volatility correlates to lower option prices. Accordingly, then, a volatility crush corresponds with a drastic loss of value for a call or put option.

Specifically, the expression “volatility crush” refers to a sudden, sharp drop in implied volatility that triggers a similarly steep decline in an option’s value. A volatility crush often occurs after a scheduled event takes place; for example, a quarterly earnings report, new product launch, or regulatory decision.

In this type of scenario, expectations for a big stock move were being priced into the options (via implied volatility) ahead of the event. Following the event, the news is priced directly into the shares, and the “uncertainty premium” drops out of the option price.

The threat of a volatility crush means option buyers should keep a close eye on implied volatility levels prior to entering a trade. If volatility is bid higher ahead of a known event, it will be relatively more expensive to buy options on that stock. Then, if the outcome of the event isn’t quite as dramatic as traders were expecting, the stock price may be little changed even as implied volatility (and, by extension, the option price) plummets. When the disconnect between implied volatility and realized stock movement is wide enough, option buyers can end up losing money on a trade, even if the shares are moving in the right direction.

A volatility crush can also occur if there’s a significant plunge in the CBOE Market Volatility Index (VIX), which would generally be the result of macro-level developments in the stock market. The risk of a broader VIX downturn is one reason why option buyers should always be wary of situations where implied volatility is running higher than a stock’s comparable historical volatility, since an unexpected volatility crush can quickly erode paper profits — or turn a modest winner into a loser.

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