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Understanding IV crush while engaging in news-based options trading


The prices on the options ticker might be faker than they appear.

The last few weeks have been eventful to say the least. The markets just weathered three huge events, namely:

  • RBI Repo rate hike
  • US inflation data
  • Federal Reserve interest rate hike

In the light of these events, many people attempted to play the market using option spreads. However, many of these positions ended up in losses instead. The culprit behind this is the dreaded IV crush.

The options market is unimaginably vast. Fortunes are created or lost on a daily basis. There's a reason why experienced options traders call the market the "options battlefield".

Options are priced using the famous Black-Scholes model. It is a differential equation that takes in five input variables: the strike price of an option, the current stock price, the time to expiration, the risk-free rate, and the volatility. Countless literature has been published on options and technical analysis of options data.

It is for these reasons that it would come as a shock to many that despite option pricing being so mathematical and technical, the options market is not 100% efficient. As with equities, options can be overpriced and underpriced as well. This happens due to implied volatility in the options market.

Implied Volatility:

Implied volatility or IV is the forecast of expected changes in the price of a security. It represents the inherent uncertainty in the market. High IV causes option prices to increase while a fall in IV causes a sharp fall in the option prices. In option greeks, volatility is represented by Vega.

Why should options traders care about IV?

A high IV causes option prices to appear higher than they should be. Traders might purchase the option hoping that a movement in the underlying would cause the option price to increase. However, they get completely caught out as even a favourable movement in the underlying is not met by the same in the option contract. Instead, the price of the option tumbles down. This happens because the change in the underlying (delta) is not enough to counter the effects of the fall in volatility (Vega).

When the above scenario happens on a large scale typically after news breaks, it is known as an IV crush.

News events and the long straddle

Economic events are some of the most anticipated times for market participants. They determine the outlook for specific securities as well as the wider market in the short term. Examples of economic events include:

  • Central bank announcements
  • Interest rate hikes
  • Earnings and Annual General Meetings
  • Mergers

One very popular way to play events is an options spread called the long straddle. To create a long straddle, one buys a call option and put option at the same strike price.

 



The basic principle of a long straddle is that there will be a heavy movement in the underlying stock price. Theoretically, one sells the losing position early and rides the winning position to massive gains.

Seems awesome right? In some cases, it is. However, this strategy is vulnerable to extreme Vega and Theta risk.

Let's understand this with a recent example. Recently on 14-15 June 2022, the federal reserve of the USA met to approve an interest rate hike to combat the soaring inflation. People wanting to play the interest hike event set up a long straddle in Bank Nifty options on 15th June.

The fed meeting concluded and an interest rate hike of 50 basis points was announced. This was in line with market expectations, which led to a gap up opening in NIFTY the next day i.e. 16th June.

However, people holding the long straddle woke up to a nasty surprise. Their call options had only risen 15-20% while the put options had lost 80-90% of their value. This was not how a long straddle was supposed to go. Unfortunately, it got IV crushed.

The volatility which was sky high on the 15th due to uncertainty about the fed hike crashed on the 16th as the hike was within expectations. This removal of volatility from the market caused the call options to not increase as much as they could have and caused an absolute crash in the prices of the put options.

Lessons learned

While playing events via carry forward options it is absolutely critical that one pays close attention to the volatility data. A lack of vigilance can lead to an irreparable financial loss as well as mental scarring.







 

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