Volatility crush is among the more common but poorly understood terms used by new options investors. They mostly place irrational bets on options ahead of earnings because they do not fully understand what they are doing.

These investors will take a look at a high-priced stock that is set to report earnings in the near-term and buy large amounts of out-of-the money call or put options with a short duration until expiration. 

These options trade at a low price because the stock has a long way to go in a short period of time to hit the strike price. So if the stock skyrockets in reaction to a smashing earnings report, the deep out-of-the money call options should come into play, and investors might assume that they are sitting on a gain of 200% or more.

For options that are trading far out of the money, a large portion of their value is derived from implied volatility. This is especially true of high tech and New Age companies that have given large growth outlooks but have offered little in terms of tangible results to satisfy investors.

In essence, if the degree of what is unknown heading into an earnings release is high, an option’s implied volatility is high. For example, will a cloud company deliver on management’s 40% revenue growth guidance? Will a new artificial intelligence cybersecurity company become profitable a year earlier than originally expected?

Before the earnings report is released, the level of uncertainty is high. But after the earnings release and follow-up conference call, much that was unknown is now known. Management will either live up to high expectations or they will not.

What happens next is often a dramatic drop in implied volatility. This is an anticipated outcome because some, most, or all of the prior uncertainty surrounding the company’s direction is now gone and priced out of the option.

Assume that company XYZ is scheduled to report results in 15 days and an investor believes the results will exceed expectations by a wide margin. If shares in XYZ are trading at $270, an investor could bet on the $300 call options that expire three days after the earnings report, for $3.00 per option.

The stock price must rise at least $30 in the next 18 days for the option to have any chance of expiring in the money.

The implied volatility for this and all option contracts can be found on a brokerage platform. Assume in our example that it is 59%.

We can calculate the expected move of the stock by multiplying the stock price times the implied volatility times the square root of the number of calendar days divided by 365.

In our case, this translates to: $270*59%*.22 = $35.04. This means that the stock could rise to $305.04 or fall to $234.96.

At $305.04, the option would be in the money, but investors should not celebrate quite yet. Many investors who thought they had hit a jackpot could wake up the next morning to see their option barely making any money, or even losing money.

This is because of implied volatility. As previously noted, implied volatility tends to fall after an earnings release. So some of the variables that make up an option price may cause the option to increase in value, while a large drop in implied volatility could more than offset those gains.

In other words, fluctuations in implied volatility “crushed” your option position.