How implied volatility behaves ahead of a stock’s earnings
implied volatility (IV) for call options (and puts) generally rises before earnings as uncertainty increases. This phenomenon is known as the "volatility crush effect." Here’s why it happens:
Why IV Rises Before Earnings:
Increased Uncertainty: Traders anticipate a significant price move after earnings, so demand for options (both calls and puts) rises, driving up IV.
Market Expectations: The market prices in potential volatility, even if the direction of the move is unknown.
Hedging Activity: Institutions and traders hedge their positions with options, increasing demand and raising IV.
Historical Precedence: Stocks often experience sharp movements post-earnings, leading to a natural increase in IV ahead of the event.
What Happens After Earnings?
IV Crush: Once earnings are announced, the uncertainty is resolved, and IV drops sharply, even if the stock moves significantly.
Option Premium Decline: The decrease in IV leads to a reduction in option prices, potentially wiping out gains from a correct directional bet if the move isn’t large enough.
How to Trade This Effect?
Buying Calls/Puts Before Earnings: Risky because IV crush can offset directional gains.
Selling Options (Iron Condors, Straddles, or Strangles): Can benefit from IV drop but carries directional risk.
Buying Options Well in Advance: Buying calls or puts weeks before earnings and selling before the announcement can benefit from rising IV.
