Volatility Crush

Understanding the affect of how volatility in the market will influence premium prices can be extremely lucrative if you were to integrate a strategy which solely centers on trading volatility premiums around binary events such as earnings

Bullish Option | Straddles
How to play volatility crush using iron butterfly strategies to profit from binary events such as corporate earnings.

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Volatility will significantly influence the price of stock options.  As you approach a binary event such as a corporate earnings announcement, volatility will steadily increase.  In contrast, when traders relax days and even moments after an earnings event, the implied volatility will plummet.  The sudden and dramatic fall in volatility is referred to as volatility crush.   And if it is understood that option premiums will increase with increased volatility; and that options premiums will fall with lower implied volatility, you know enough to set up a strangle or iron condor to take advantage of this single principle.

General Principle:

Buy an options contract on a stock that is about 20-30 days out from reporting their earnings.

  • As earnings approaches, premium paid on the stock will increase as the implied volatility inherently increases.
  • The premium of paid on the stock option is highest one hour before the earnings announcement.
  • If you sell the stock that you had bought, 20-30 days out, you will make a profit even if the underlying stock did not move.
Sell an iron condor on a stock option about 1 hour before before earnings
  • Premium on a stock is highest about one hour before an earnings announcement.  
  • It follows that the amount of credit you can receive from a selling premium strategy such as straddles and strangles, or iron butterflies and iron condors is highest just moments before an earnings announcement.  
  • Volatility, and with it, premium prices will plummet the day or moments after an earnings announcement.  
  • It follows that buying back the contract now that the premiums are as much as 3x lower will net you a significant profit.  

 

The first profit target is generally 25% of the maximum profit. This is done by buying the straddle back for 75% of the credit received at order entry.

An increase in implied volatility follows from an increased tension and uncertainty in the market.  A clear example of this effect is how stock react as they approach a binary event such as their corporate earnings.  

Because of the increased uncertainty, market makers will increase the premium on stock options that they are selling to compensate themselves for the increased risk that they are taking from selling options that could move against them.  The market maker will build enough premium into the stock option compensate themselves for a significant and perhaps unexpected move in the stock after the earnings announcement.

An straddle is a premium collection strategy that is created by selling an at the money call and an at the money put at the same time.  

An iron butterfly is a a premium collection strategy that is set up the same way as straddle with a ATM call and an ATM put, but will have the addition of protective OTM long options for wings; the protect wings are placed between 5-10 dollars away from the ATM short options.  

The pros and cons of the straddle include a significantly larger profit potential but at the expense of an infinite loss potential.  The strategy will also eat up a huge part of your margin collateral.

The pros and cons of the iron butterfly include a more limited but significant profit potential but will limit the loss potential.  Because of the protective wings, the strategy will require only a fraction of the margin collateral required vs the straddle.

While it is true that the actual profit is potentially larger when establishing a straddle vs an iron butterfly, the return on capital is actually significantly less for the straddle.  

This is because a straddle will require a huge margin collateral.  The collateral is set aside by the broker in case the trade goes badly for you; as a straddle is essentially a naked ATM call and a naked ATM put with the potential for infinite losses.  The set-aside margin collateral is actually a huge drain on your overall capital as you will not only not be able to use it for other trades, but it is essentially the risk that you are taking on the trade ( infinite risk ).  

Therefore, even though the straddle my net you a greater profit than a butterfly, the return on capital, or the percent of profit vs the capital risk is significantly lower for the straddle vs the butterfly.  

Option Basics

How do you set up a volatility crush options strategy?

  • Buy an options contract on a stock 20-30 days before its earnings announcement
  • Close by selling the stock back 1-2 hours before the earnings announcement
  • Sell an iron condor 1-2 hours before an earnings event for a significant premium
  • Sell the iron condor within one hour after the earnings announcement ( this will most likely be the next day )

Option Basics

Volatility Crush

Setting up a strategy to capitalize on volatility crush

  • Sell an iron butterfly 5-10 points wide 1-2 hours before an earnings call
  • Buy to close the iron butterfly within the first hour ( as early as possible ) the next day after an earnings call.
  •  Positive Delta – C

Option Basics

Example

Calculating profit and loss for an iron butterfly

  • If you were to buy a short call and put for an elevated premium

Calculating profit and loss for an iron butterfly

  • If you were to close the trade by selling the calls and puts the day after because of volatility crush.