With earnings season now upon us again, we took another crack at working through volatility crush. When the option’s market prepares for a binary event of some sort, such as a jobs number, a Fed announcement, or an earnings release, the front month option contract gets inflated with astronomically high implied volatility. This is because the IV for a given expiration cycle is simply a weighted average of all the daily IVs for that cycle. The earnings day will trade with an exaggerated IV, as that day houses the binary event. Therefore, option contracts that contain the earnings day will trade at higher prices.
However, this effect is much more pronounced for the contracts that have very few days to expiration, such as the front month contract. On a contract with only a handful of DTE, the abnormally high IV earnings day will carry a lot of weight relative to the few “normal” IV days. Contrast this with an option’s contract that also contains the earnings day, but it has 30, 40, or 50 DTE, such as the back month option’s contract. Here, the abnormally high IV earnings day will be outweighed by the higher number of days with normal IV. Once the binary event is over, volatility levels will return back to normal, as is represented by the back month. The volatility crush is the difference between this front month volatility and the back month volatility.
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