Volatility and event risk

Lessons 1 to 5 assumed that options were worth selling. This lesson is about testing that assumption, trade by trade. Two questions decide it: is implied volatility high relative to what the stock is likely to deliver, and is there a single event inside the trade's life that could move the stock far more than usual? The background is in the Learn articles on historical versus implied volatility, the term structure and IV crush.

Is volatility rich? Three lenses

1. Implied against realized

The most direct test compares 30-day implied volatility with the volatility the stock has recently realized, for example over 20 and 60 trading days. A ratio well above 1 means options are priced for more movement than the stock has been producing; well below 1, the opposite. The ratio is a starting point, not a verdict: before earnings it is supposed to be high, and after a calm stretch realized volatility can understate the risk.

2. IV rank and IV percentile

Both place today's implied volatility within its own past year, but they answer different questions:

• IV rank = (today's IV − 1-year low) ÷ (1-year high − 1-year low). It measures where IV sits between the extremes.
• IV percentile = the share of days in the past year on which IV was lower than today. It measures how unusual today's level is.

A single spike inflates the high and depresses IV rank for months afterwards, which can hide that premium is in fact elevated. Reading both, together with the IV-to-realized ratio, gives a fuller picture than any one number.

3. The term structure

Normally longer-dated options carry higher IV than near-dated ones (an upward curve). When near-dated IV rises above later expiries, the curve is inverted: the market is paying for protection now, a sign of stress or of an event close by. A single expiry standing above its neighbors marks an event priced into that date. For a seller, an inverted curve is a warning, not an invitation: the premium is high because the market expects movement soon.

The expected move

Implied volatility converts into a price range: expected move ≈ price × IV × √(days ÷ 365). For a $150 stock with 40% IV and 30 days, that is 150 × 0.40 × √(30 ÷ 365) ≈ $17.20. Under a normal approximation the stock ends within ±$17.20, from $132.80 to $167.20, about 68% of the time, and outside it about a third of the time. The at-the-money straddle gives a similar figure; it equals about 0.8 times the one-standard-deviation move, here about $13.70. See the Learn article on the expected move.

Measuring short strikes in expected moves makes trades comparable across stocks and expiries. A short strike inside the expected move can be reached by an ordinary move; one at 1.5 expected moves needs an unusual one. Remember that roughly one outcome in three falls outside a one-standard-deviation band, and that real returns have fatter tails than the normal curve.

Earnings and IV crush

Before a scheduled report, options spanning the date carry an extra premium for the expected jump. Because the jump falls within a few days, the nearest expiry after the report shows the largest rise in IV. Once the result is out, the jump is gone and IV collapses toward its normal level. That collapse is IV crush.

Crush is why selling premium into earnings is tempting. Illustrative numbers: a $120 stock reports after the close; the 5-day at-the-money straddle costs $9.60, so the market prices a move of about 8%. Over its last eight reports the stock moved 5% on average, but its largest reaction was 14%. A seller of the straddle, with IV falling to 38% the next morning and four days left:

The average says the options are rich: 8% priced against 5% delivered, a ratio of 1.6. The distribution says something else: one report in eight produced a 14% move, which would have cost this seller about $7.20 a share, more than the gains from two typical reports, and an unhedged short straddle has no ceiling on the loss. Earnings premium is not mispriced simply because the average move is smaller; the seller is paid for the tail.

Binary events: rules for standing aside

Earnings are the most common binary event, but not the only one: drug trial results and regulatory decisions, court rulings, merger votes, and, for index options, central-bank decisions and inflation reports (see FOMC and CPI). Practical rules:

• Do not hold undefined-risk short premium (short puts, covered calls you cannot afford to lose, short strangles) through a binary event you have not chosen to trade.
• If you trade the event, use defined risk only, size it so the full maximum loss is small (for example 0.5–1% of the account), and require the priced move to exceed both the average and most of the past reactions.
• Prefer to open income trades after the event, when the crush has already happened and the uncertainty is resolved.
• Check every expiry for scheduled dates before opening, including the ex-dividend date for short calls.

How to apply it

• Entry. IV at least moderately above realized volatility; IV percentile, and preferably IV rank, in the upper half of the year; term structure upward or flat; no binary event before expiry; short strikes at or beyond one expected move.
• Target. In high-IV regimes premium decays faster when volatility normalizes: take the usual 50% target promptly.
• Stop. An IV jump of several points without news, or a term structure that inverts after entry, is a reason to cut size even before the price stop is reached.
• Invalidation. A newly scheduled event inside the trade, realized volatility overtaking implied, or a gap through the expected move.

In Clear Tape

On the Options page, the free index cards for SPY, QQQ and IWM show each index's term structure, skew and expected move for the week. For any stock, Pro members see 30-day IV and its daily change (flagged when it jumps 3 points or more), 20- and 60-day realized volatility, IV divided by realized (rich at 1.3 or more, cheap at 0.8 or less), and the one-year IV rank once 60 days of history exist; the IV-by-expiry chart marks an expiry priced for an event. The Earnings panel shows the next report date and session, the move priced in (the at-the-money straddle of the first expiry after the report) against the average move of up to the last eight reports, and reads it as rich at 1.2 times the average or more and cheap at 0.8 times or less once four reports are available; its bar chart shows every past reaction, so the largest is visible too. In the strategy builder the expected move to expiry is the at-the-money straddle, so in the $150 example a 130 put would sit about 1.5 expected moves away. Checks warn when earnings or an event-priced expiry fall inside the trade, and when earnings come before expiry the credit spreads, iron condor and butterfly, cash-secured put and wheel are rated a poor fit. Data reflects the previous session's close; upcoming reports are also on the calendar. See pricing.

Common mistakes

• Selling because IV rank is high without checking whether a known event explains it.
• Judging an earnings trade on the average past move and ignoring the largest.
• Reading a one-standard-deviation range as the limit of what can happen.
• Treating an inverted term structure as an opportunity rather than a warning.
• Forgetting that payoff lines which hold IV constant cannot show a crush or a volatility spike.

Summary

Premium is worth selling when implied volatility is high relative to what the stock is likely to realize, and when no single event can overwhelm the trade. Use the IV-to-realized ratio, IV rank and IV percentile together, read the term structure for stress and events, and place strikes in terms of the expected move. Earnings crush is real, but it pays for a tail that occasionally arrives; trade it only with defined risk and small size, or wait until it has passed. The final lesson turns all of this into a written plan: position sizing and a trading plan.

For educational purposes only. Not investment advice.