IV crush and pre-earnings positioning risks
Lesson 16 · about 10 min
The last lesson in the earnings playbook is about the decision every holder faces: what to do with a position before the report. The options market gives you a number to make that decision with, the implied move, and it also sets a trap for anyone who buys options into the event without understanding what happens to volatility afterwards.
The implied move
Options prices embed the market's estimate of how far the stock will move. Around earnings, the nearest-expiry options carry a premium for the event, and you can back out the expected move from the price of an at-the-money straddle (a call and a put at the same strike, both bought).
Rough rule: implied move ≈ price of the at-the-money straddle expiring just after earnings, divided by the stock price.
ACME at $40, earnings in 11 days. The $40 call expiring next Friday is $1.70 and the $40 put is $1.50. The straddle costs $3.20.
Implied move ≈ $3.20 ÷ $40 = 8.0%
The market is pricing roughly an 8% move in either direction, about $3.20. Compare with ACME's last four reactions (+6%, −4%, +9%, +8%; average absolute 6.75%). The options market is pricing slightly more than history, which is common; the premium reflects the chance of a much bigger move.
The options fundamentals course covers how implied volatility is calculated and what a straddle is. Here the point is only that the implied move is a free, market-generated forecast of the size of the gap, and it is the number to compare with your stop.
Key idea: The at-the-money straddle price divided by the stock price is the market's estimate of the earnings move. If it is larger than your stop distance, your stop will not protect you through the event.
The stop that cannot work
A swing trader long ACME at $40 with a stop at $38 has a 5% stop. The implied earnings move is 8%. If ACME gaps down 8% it opens at $36.80, and the stop fills at $36.80 or worse, not $38. The planned 1R loss becomes a 1.6R loss. On a 12% gap it becomes a 2.4R loss.
| Gap size | Open price | Planned loss (stop $38) | Actual loss | Loss in R |
|---|---|---|---|---|
| −5% | $38.00 | $2.00 | $2.00 | 1.0R |
| −8% | $36.80 | $2.00 | $3.20 | 1.6R |
| −12% | $35.20 | $2.00 | $4.80 | 2.4R |
| −20% | $32.00 | $2.00 | $8.00 | 4.0R |
Gaps of 20% on earnings are not rare in smaller stocks. A trader who holds full size through reports is running a risk plan that is fiction on four days a year per stock. The risk management course treats overnight gap risk generally; earnings is the specific, scheduled version.
The three choices
1. Exit before the report. The cleanest option. The drift trade from lesson 3 already ends before the next print. Taking a swing trade off the day before earnings, then re-entering after the reaction if the setup is still valid, costs a little in commissions and missed gaps up, and saves the occasional catastrophe.
2. Reduce to gap-survivable size. If you want exposure through the event, size so that the implied move (or better, 1.5 times the implied move) equals your 1R. For ACME: 1.5 × 8% = 12%, or $4.80 a share. With 1R of $300, that is 62 shares, not the 150 you would hold with a $2 stop. The position is a quarter of normal size, and a 12% gap costs 1R as planned.
3. Hold full size and accept it. Sometimes done deliberately by traders whose thesis is specifically about the report. It is a bet, not a trade with a stop, and should be logged as such. The honest accounting is: expected loss is the probability of a bad gap times its size, and no stop changes that.
IV crush
Now the trap. Implied volatility on ACME's near-dated options is elevated before earnings because of the event. The moment the report is out, the uncertainty is resolved, and implied volatility collapses, often by 30% to 60% overnight. This is IV crush, and it means an option can lose value even when the stock moves in its favour.
ACME example. Before earnings, the $40 call expiring next Friday is $1.70 with implied volatility at 75%. ACME reports and rises 4% to $41.60. The call is now $1.60 in the money, but implied volatility has dropped to 35%. The call trades at roughly $1.85.
The stock went up 4% and the call went up only 9%; the volatility crush ate most of the move. At +2% the call would likely have lost money outright, and at −4% it would be nearly worthless.
| Outcome | Stock move | Call before | Call after | Call P/L |
|---|---|---|---|---|
| Up, larger than implied | +10% | $1.70 | $4.10 | +141% |
| Up, near implied | +4% | $1.70 | $1.85 | +9% |
| Flat | 0% | $1.70 | $0.55 | −68% |
| Down | −6% | $1.70 | $0.08 | −95% |
The figures are illustrative; the shape is what matters. Buying options into earnings is a bet that the move will exceed the implied move. Since the implied move is the market's average expectation, that bet loses slightly more often than it wins, before costs.
Two further positioning risks: short options into the event collect the elevated premium but carry the tail (a 20% gap can cost many times the premium), and chasing a stock that is up 10% into the print means buying where the whisper is high and the crowd is already long.
The decision for ACME
The trader is long 150 shares at $40 with a stop at $38 (1R = $300). Earnings in 11 days, implied move 8%, historical average 6.75%, stock up 5% into the print. Their process:
- The current swing trade was a breakout with a two-week horizon. The report falls inside that horizon.
- Option 1: exit the day before, re-evaluate after the reaction. If the report is a beat-and-raise with a held gap, re-enter on the drift setup.
- Option 2: reduce to 62 shares, which makes a 12% gap equal to 1R.
They choose option 1, because the setup was technical and had no thesis about the report, and because the stock has already run into it. Later, if ACME gaps up and holds, they treat it as a fresh drift trade with a stop under the gap-day low.
Try it: For any stock reporting next week, find the at-the-money straddle price for the expiry just after the report and compute the implied move. Compare it with the stock's last four earnings-day moves. Then compute how many shares you could hold so that 1.5 times the implied move equals your 1R.
Recap
- Implied move ≈ at-the-money straddle price ÷ stock price; it is the market's estimate of the gap.
- A stop tighter than the implied move offers no protection through the event; losses in R scale with the gap.
- Choices: exit before, reduce to gap-survivable size, or hold and log it as a bet.
- IV crush collapses option prices after the report; long options need a move larger than implied just to break even.
- Do not anchor on recent reactions or chase a stock that has already run into the print.
See it drawn
Original diagrams for the ideas on this page. Illustrative, not real market data.