May 11 2021 - Tesla: Beware Of The Unwinding Of The Gamma Squeeze
- Tesla and other EV shares have been under some selling pressure in the last three months, the EV bubble is slowly deflating.
- Adverse publicity in China and increasing concern about the safety of Tesla’s FSD option is adding to the downdraft.
- Intense competition in key markets and construction delay at the German factory do not help.
- Selling pressure could intensify in the second half of the year as call options expire, reversing last year's gamma squeeze.
The automotive industry is a highly competitive, capital intensive, low margin business at the best of times. It is also a very difficult business to enter. In addition to massive capital requirements, success in the automotive business demands talented and experienced engineers, a network of factories, and powerful logistics to manage the complexities of the supply chain and manufacturing process.
In the company’s recent earnings call, Tesla (TSLA) CEO, Elon Musk, compared it to the logistics of managing World War 2. His claim was perhaps a slight exaggeration, but it illustrates the point.
Despite the low-profit margins and past failed attempts by the likes of Bricklin and DeLorean to enter the business, the promised advent of electric cars has produced a new wave of would-be automakers. Investors have piled into shares of these new entrants hoping to duplicate Tesla’s skyrocketing share performance, driving prices into bubble territory.
However, Tesla’s financial results continue to demonstrate that the electric car business is no different from the rest of the automotive business. As more competition enters the BEV market prices are squeezed until profit margins are razor-thin. After 16 years of losses, Tesla finally reached profitability, not from selling cars, but from selling regulatory credits to other automakers. I think Tesla has clearly demonstrated that from a profitability viewpoint, electric cars are just cars with a different drive-train and the transformation to electric drives does not change the fundamental nature of the automotive business.
The EV bubble is now deflating, Tesla is down 30% from its January high. Tesla’s would-be imitators have fared even worse, Lordstown Motors (RIDE) is down 73%, Fisker (FSR) -60%, Canoo (GOEV) – 62%. Tesla’s Chinese competitors' share prices are also falling, despite sharply rising sales. NIO (NIO) is down 40% and XPeng (XPEV) and Li Automotive (LIV) have both fallen more than 50%.
Against this backdrop of falling share prices among EV companies, Tesla is facing a few headwinds of its own including:
- Adverse publicity resulting from quality and safety issues and a public backlash that will probably impact sales in China, its fastest growth market
- Increasing doubts about the safety and capabilities of Tesla’s Full Self Driving option, and the associated liabilities
- Construction delays at the German factory
- Intense competition from legacy automakers in its key markets
But there is one factor that does not get the same attention in the media but may have an impact on Tesla’s share price in the second half of this year. It is the potential selling pressure from the high volume of “in the money call” options that expire in the next year – The unwinding of the gamma squeeze that some investors claim was the reason why Tesla’s shares reached their astronomical heights last year.
Option hedging has a significant impact on Tesla’s share price
Typical trading volumes for TSLA options are around 1 million contracts per day, equivalent to 100 million shares. Share volumes are around 30 million per day, which includes volume generated by market makers option hedging. With those relative volume levels, options trading is certain to have a significant influence on Tesla’s share price.
Delta hedging and the gamma squeeze
When option market makers sell an option, they hedge their exposure by buying shares (or selling if they are exposed to put options). The number of shares they buy or sell (known as Delta) depends on the relative price movement between the option and its underlying share.
The value of Delta changes with the share price and the time to expiry. The chart below shows how those changes affect the number of shares that the option market makers buy to hedge their call option exposure. Three curves are shown with one-week, four-week, and one-year expiry dates, the X-axis is the share price relative to the option strike price.
Variation of option price with share price and expiry: Data sourced from Option Council
Last year, when Tesla shares were hot, a lot of investors bought long-dated “out of the money” call options which would have been delta hedged by the option market makers. The green curve on the chart above is the delta curve for options with a 1-year expiry. As an example, a 0 call contract (,000 pre-split) bought a year ago, would have been on the left edge of the green curve, it would have been hedged at the time with the purchase of about 28 shares.
If the share price had stayed the same over the past year, those shares would have been gradually sold as the delta curve moved towards the orange and blue curves. However, Tesla's share price has risen and is now about 170% of the 0 call option strike price, the delta is 0.98, another 70 shares have been purchased for hedging.
This additional share buying for hedging is the "gamma squeeze". It has been one of the factors driving the price of Tesla shares upwards, and it will be a factor driving the share price down as the squeeze unwinds with the expiry of the options.
Option expiry and the unwinding of the gamma squeeze
As the expiry date approaches, delta tends to a value of 1.00 for in-the-money options and zero for out-of-the-money options. In theory, market makers would like to be holding, at expiry, one share for every ITM call option minus one share for each ITM put option to which they are exposed.
If the options are held to expiry, they are exercised and the long or short position transfers to the option holder, with no effect on the market. However, most option holders do not hold the option to expiry, many will sell the option before expiry or hedge the position by buying or selling shares.
Selling an ITM call option that has a delta of close to 1 causes the market maker to sell 100 shares and selling an ITM put option with a delta of close to 1 causes the market maker to buy 100 shares, so an imbalance between open interest in ITM calls and ITM puts will result in a net sale (or purchase)
If option trading were the only driver of market prices the share price on expiry would trend towards the point where the open interest in ITM calls equals the open interest in ITM puts. I’ll refer to that as the put/call balance point.
The effect of short expiry versus long expiry options
Most weekly options don’t come to the market until 8 weeks before expiry, they tend to be traded at strike prices close to the share price, so the put/call balance point is usually close to the share price, and the impact on expiry is small.
But the options that have been on the market for longer, the June, September, and January regular options show a strong imbalance between ITM calls and ITM puts, and much higher overall open interest. Option market makers are holding significant long positions to hedge those ITM calls, and those long positions will unwind as the calls approach expiry, releasing millions of shares onto the market.
Based on data from May 7th, open ITM call interest in the June 18th options exceeds ITM put interest by 170,000 contracts (17 million shares), the balance point is at 0 as shown in the chart below:
If this theory is correct, as the upcoming June 18th call option expiry approaches it will tend to push the Tesla share price towards 0 as the gamma squeeze unwinds, creating downward pressure on the share price.
This does not all happen on options expiry day, open interest in the June ITM calls has been falling steadily since I started keeping records in February, indicating that some investors have been taking profits already.
A falling share price generates downward gamma
In addition to the effects of options expiry, there is the gamma effect as the share price moves up or down. The delta values move up or down their respective curves and option market makers buy or sell options to maintain their hedges. A falling share price generates selling of shares to unwind option hedges for all options, not just the expiring options, and it has the same directional effect for both puts and calls, i.e. selling when the price moves down and buying when the price moves up. This effect will magnify any downward moves, just as it magnified upward moves as Tesla’s share price rose last year.
If you Google "gamma squeeze" you will find many articles describing how heavy call buying forces share prices up, but very few of those articles mention that the gamma squeeze works in both directions.
Summary and Conclusion
There is a large volume of deep-in-the-money call options purchased during Tesla’s share price run-up last year that will expire June 18th. This option expiry may precipitate selling as the option positions are closed and market makers remove their delta hedges. This will put downward pressure on the share price as the options expire. Further downward pressure is likely as the September and January options move towards expiry.
Options trading is not the only factor that determines share prices but combined with other factors that appear to be pressuring Tesla’s share price at present, I think this would be a good time to take profits if you hold a long position, and don’t be tempted to buy the dip if the share price drops over the next few weeks.
A note about data source and possible inaccuracies
All the information used to develop the charts, calculations, and conclusions in this article has been downloaded from The Options Council website. The information has some flaws which limit the accuracy of the data.
Option open interest is posted on the site daily before the market opens. The information posted is total open interest, not net open interest. If someone holds a long call and someone else holds a short call of the same strike and expiry, those positions will post as two open interests. That introduces inaccuracy in the data because we don’t know how much of the stated open interest is long and how much is short.
However, I believe that most of the long-dated deep-in-the-money calls will be long positions and the conclusions are valid.
I hold a very small position in July puts.