Every quarter, most publicly traded companies release earnings reports to inform shareholders of their sales, profits, outlook for next quarter etc. Upon and preceding the release of these reports, fear strikes in the market. When fear is high, a stock's price is considered volatile and there is inflated implied volatility (IV) in the derivatives/options market. Increased implied volatility corresponds to increased option prices, allowing traders, who are typically premium sellers, to open short positions. Post earnings announcement the implied volatility collapses and the options price kind of 'normalizes'.
To get a sense of this heightened IV prior to earnings, you can look at the options chain. The options chain closest to the earnings date (front month/week) will display an very high IV when compared to the other options chains going out farther in time (back month/week). Say if the front week is displaying an IV of 25% and the back week is displaying an IV of 20%, we can infer that post earnings announcement, the IV of the front week will collapse by about 5%. This 5% volatility crush to is the volatility contraction that the premium sellers are counting on to profit off of. The greater the volatility contraction, or "crush", percentage, the greater traders with short position profit.
Eighteen-year old trader, future connoisseur of options.
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