There’s some volatility trading jargon that you may come across from time to time and that is the concept of volatility crush, or sometimes just vol crush.
So what is volatility / vol crush?
Volatility tends to rise when we’re moving towards events with unknown outcomes. This is the normal volatility risk premium. Traders need to be compensated more for taking on unknown event risk, and the more extreme the event is viewed by people, the more implied volatility will tend to rise.
However when the outcome becomes known and there’s no more uncertainty, markets can then react to the news which is represented by realized volatility, or the actual movement of the market.
– If the outcome was decidedly negative, markets may fall and in that case volatility would tend to continue rising, perhaps even spiking violently. Sometimes the increasing volatility turns out to be justified.
– If however the outcome was decidedly positive, or sometimes even just neutral is good enough, in those cases volatility can decline rapidly.
That is vol crush
Examples of when this happens would be earnings announcements by companies, or monetary policy announcements such as Fed interest rate decisions.
The date of the announcement is known well ahead of time but the outcome of course isn’t, so implied volatility rises heading into it. Then if the market reacts very positively to the news, that built up volatility can deflate like a balloon very quickly… Vol crush.
Quite often it’s political events. For example, all of last week the US Senate was going back and forth on whether they have the right tax plan, and more importantly whether they have enough votes to get it passed. The market knew there would be a vote at the end of the week, but didn’t know the outcome. Take a look at the VIX action heading into the event:
VIX Index from Monday Nov 27th – Friday Dec 1st
Now this is clouded a little bit by the fact that on Friday ABC news threw out a misleading report on the Michael Flynn investigation that spiked the VIX all the way to the mid 14’s, but even without that you can see that for 4 days the VIX was slowly rising into the unknown outcome of the Senate vote on the tax bill.
Outcome: The vote went 51-49 in favor of the the tax cuts bill (or the tax raise bill depending on your situation) so today we’re seeing some vol crush. The VIX could easily drop back down to the levels it was to start last week.
Now for anyone out there thinking hey, why don’t we just short volatility heading into all these events and profit from the vol crush afterwards? Sounds good in theory, but in my opinion that’s not the best long-term strategy.
Remember risk is asymmetric which means it’s not equal on both sides. It’s true that shorting volatility heading into unknown events can be profitable when the vol crush on the other side kicks in, but remember if the news does turn out to be bad, markets can deteriorate a lot faster than they can recover.
My strategies don’t front run any news. We take the signals as they come. The VTS Aggressive Vol strategy is in SVXY right now, but not because of anticipating any vol crush. It’s long SVXY because that’s what it’s indicators were flashing last week.
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