Implied volatility crush, or IV crush, occurs when option premiums plummet due to a sudden decrease in implied volatility. This can lead to losses even when you correctly predict the direction of the underlying asset. Recently, IV crush has been a major concern due to the inverse correlation between implied volatility and the underlying asset's direction.
The Inverse Relationship Between Implied Volatility and Underlying Asset Direction
Generally, when the price of an underlying asset rises, its implied volatility tends to decrease. Conversely, when the price falls, implied volatility tends to increase. The stock market's recent behavior illustrates this: as the market collapsed, implied volatility surged to record levels. However, during market bounces, implied volatility collapses just as dramatically. Therefore, buying calls during a bounce, hoping to profit, can be risky as the decrease in implied volatility might outweigh any gains from correctly predicting the underlying's direction.
Strategies to Hedge Against IV Crush
Fortunately, there are strategies to hedge against IV crush or Vega exposure. The following are three common methods:
1. Utilizing Spreads to Limit Vega Exposure
Spreads can effectively limit Vega exposure. A spread involves buying and selling options on the same underlying asset but with different strike prices or expiration dates. This approach reduces the impact of implied volatility changes on the overall position.
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How Spreads Work: When you buy a call option, someone else is selling it. When you make money if implied volatility increases, the seller loses money. By selling a call option in addition to buying one, you create a position where the Vega exposure is partially or fully neutralized.
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Vega Neutralization: For example, buying a call with a Vega of 13 and selling a call with a Vega of -13 effectively creates a zero-Vega position. While this is simplified (numbers are rounded and change with the underlying price), it demonstrates the principle.
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Impact on Leverage: Reducing Vega exposure through spreads also reduces overall leverage. This may be undesirable for those confident in their position.
Important Note: At-the-money options have the highest Vega, meaning that leg of the spread closest to being at-the-money will be the most influential.
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If the long leg is closer to being at-the-money: overall you'll be long volatility, but very minimally.
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If the short leg is closer to being at-the-money: overall you'll be short volatility.
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2. Hedging with VIX Puts
Another method is to hedge SPY calls (calls on the SPDR S&P 500 ETF Trust) using VIX puts (puts on the CBOE Volatility Index). The VIX attempts to track the implied volatility of SPY options.
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How it Works: If you own a SPY call and are concerned about IV crush as the underlying increases, purchase a VIX put with a delta equal to the Vega of the SPY call. If SPY increases by $1, you make money on the call, but lose money on the VIX put. This should offset the decrease in the SPY call due to IV crush.
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Potential Drawbacks:
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Doubled Theta: Both options have theta (time decay), increasing your exposure to time decay.
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Increased Downside Risk: If the underlying decreases, you lose on both the SPY call (due to its positive delta) and the VIX put (due to its negative delta as implied volatility increases).
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Need for Adjustment: The Greeks (Delta, Vega) change, requiring periodic adjustments to maintain the hedge.
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3. Buying In-the-Money Options
Buying in-the-money options is a third way to mitigate IV crush. At-the-money options have the highest Vega. As you move further in-the-money or out-of-the-money, Vega decreases, reducing exposure to implied volatility changes.
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Why Not Out-of-the-Money? While out-of-the-money options are cheaper, buying multiple out-of-the-money options to achieve the same directional exposure can actually increase your total Vega. Also, as the underlying price rises, the out-of-the-money option moves closer to being at-the-money, increasing its Vega and vulnerability to IV crush.
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Spread Combination: Consider buying an in-the-money option and selling a cheaper, out-of-the-money option to create a wide-strike spread. This approach reduces the overall cost of the trade while still reducing the overall risk of IV crush.
Conclusion
Understanding IV crush and implementing hedging strategies is crucial for options traders. By using spreads, VIX puts, or strategically selecting in-the-money options, you can mitigate the risk of losing money even when you correctly predict the direction of the underlying asset. Careful planning and awareness of the potential downsides of each strategy are key to successful options trading.
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