Earnings Season Trading and IV Crush Cash

Hey there! My name is Nate Thomas and I write for WOLF Financial. If you enjoy learning about trading you might also enjoy my newsletter, A Trader’s Education, and more of my content on X @tradernatehere. Thanks for reading!

This service is for general informational and educational purposes only and is not intended to constitute legal, tax, accounting or investment advice. These are my opinions and observations only. I am not a financial advisor.

Earnings season is kicking off with big banks leading the way.

As they always do, the financial sector will give a glimpse of the overall health of the consumer and economy as a whole.

And in the weeks immediately after we will get a barrage of earnings reports, each one presenting a new opportunity for trading.

If you are like me, you’re not a fan of buying options heading into earnings.

Lucky for us, there are plenty of people who do. And they can be your customer.

Have you ever bought options ahead of earnings, got the direction of the move right, but still lost money?

If you trade long enough you’ve experienced this. The culprit behind this madness is implied volatility (IV).

IV represents the expected move of the underlying asset’s price. When IV is elevated, it reflects the market’s forecast of expecting bigger swings in price.

When IV is elevated the price of options are also higher.

This makes sense. A potential for bigger price moves equates to a potential for larger gains which means you have to pay a higher price to play.

Simply put, increases in implied volatility create higher options premiums and lower IV decreases them.

Another way to look at IV is as a measure of uncertainty. The higher the level of uncertainty, the higher the IV and therefore the higher the option price.

Earnings season comes with a lot of uncertainty that ultimately decreases after the data is reported.

This is where the money is made, but not by being a buyer but instead by selling options.

IMPORTANT NOTE: Selling unsecured options is highly risky. I only advocate selling covered calls and cash secured puts as both have defined risk and losses are capped.

As mentioned, banks kick things off at the end of the week and then earnings season will be in full stride.

When earnings are reported, uncertainty is generally reduced. There are a lot of questions heading into the report date and those questions largely get answered.

This reduction in uncertainty equates to a reduction in IV and effectively a reduction in options prices.

This is because the price of an options is comprised of multiple components, and volatility is one of them.

The massive drop off in IV is known as the “IV Crush” and it is a great for sellers of options as long as the price of the underlying doesn’t move dramatically.

If you bought the options, IV Crush is not your friend.

In addition to getting the direction of the move correct, you now need to overcome the drop in value of the option that comes from the drop in IV.

Take a look at the charts below for STZ. The top panel is the price, and the bottom panel is IV through each earnings report.

IV dropped off dramatically each time STZ reported, and sellers of these options enjoyed the premiums they collected ahead of earnings.

This quick decline in IV is a common occurrence and probably why it was rewarded with a nickname. Experienced traders all know about IV Crush.

How Does it All Work?

There are a handful of components that comprise the price of an option.

1. Intrinsic value - the difference between the underlying stock price and the strike price of the option.

2. Time Value - the value of the time remaining before expiration of the options contract.

3. Volatility of the stock - the expected volatility adds to the price of the options contract.

4. Risk Free Interest Rate - this has a smaller impact overall and is referred to as Rho

Volatility plays a part in the overall price of an option and should be considered before entering an options trade.

Earnings season is notorious for seeing IV rise ahead of time and as speculators start placing their bets. If IV is elevated above historic levels, it is a great time to take advantage by selling options and collecting the bolstered premiums.

That being said, selling options without having the shares or cash already in place to secure your positions is not something I advise or ever do.

Covered calls and cash secured puts are great ways to take advantage of the IV Crush that comes with earnings season.

You do give up potential additional profits because you are capping what you can earn on the trade, but you are paid for this trade off.

If you find stocks that have higher IV the price action might move a lot more than a less reactive ticker. But it may not move as much as the IV suggests, and that is where you can make some additional cash.

If you are going to be a buyer of options ahead of earnings, be sure to check on the level of implied volatility and understand how it is impacting price.

Have a great week ahead and thanks again for reading!

-Nate

 @tradernatehere