Upbeat investors exposed to any Europe stocks setback

Thu Dec 20, 2012 10:20am EST

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* Strong interest in upside bets via call options
    * Short bets on major indexes down in past month
    * Upbeat positioning leaves market vulnerable to weakness

    By Toni Vorobyova
    LONDON, Dec 20 (Reuters) - Expectations that European stocks
will go from strength to strength in early 2013 have fuelled
demand for options that would profit from such a rally but left
investors exposed to any setback.
    European indexes are set to outperform U.S. ones for the
first time in three years this year after the risks of a euro
zone break-up were reduced by pledges of central bank help.
Stocks also look historically cheap and fund flows are rising.
    Investors burned by the euro zone crisis are slowly turning
more upbeat, snapping up call options which allow them to profit
if stocks rise. At the same time, investors are less inclined to
short stocks by borrowing them and betting they will be able to
buy them more cheaply when they have to make good the loan.
    By betting on market gains in early 2013 rather than this
month, European investors are also hoping to cash in on an
expected resolution by U.S. politicians of the "fiscal cliff" of
recession-threatening spending cuts and tax hikes. 
    The problem is, if equity markets go down rather than up,
investors have bought so little protection in the options market
that any downward move could accelerate quickly.
    "The worrying concern is how little hedging funds have,"
said Andy Ash, head of sales at Monument Securities. "The market
is majorly under-hedged should any down move occur."
    A deal to avert the fiscal cliff is widely expected before
the end of this year, but the exact timing is unclear,
potentially keeping the market more cautious about December
options contracts, which expire on Friday. 
    Investors' appetite for call options on the Euro STOXX 50
 has surged sharply in the past month, outstripping
growth in downside 'put' bets. Traders said demand could rise
further if profits made on December contracts are reinvested.
    "The positioning has definitely been more bullish," said
Kokou Agbo-Bloua, European head of equity and derivative
strategy at BNP Paribas. "Calls for January or March are a very
smart trade to protect yourself through the fiscal cliff without
getting exposure to the downside." 
    The number of call contracts for January expiry on Eurex,
Europe's top equities derivatives exchange, has risen nine times
since mid-November as investors step up bets for 2013, while
puts are up 5.8 times.
    
    Such bets are historically cheap at the moment, with implied
volatility on the Euro STOXX 50 - a key influence on the
cost of an option on the index - having halved in 2012 and
currently at the bottom of a five-year range.
    Further boosting demand for calls is the fact that many
investors are still underweight Europe following concerns about
a possible euro break up earlier this year and the ongoing
sovereign debt struggles of several euro zone members. 
    U.S. investors, many of whom have had low exposure to the
region for years, are becoming more upbeat and have added money
to European funds for 10 weeks in a row. But there is still a
long way to go: current holdings of around $15 billion are half
their 2007 levels, according to Thomson Reuters Lipper data. 
    "They don't need puts because they are underweight Europe in
general and they have been buying calls to gain exposure in case
of a rally," BNP's Agbo-Bloua said. 
    History suggests the trade could be successful, with Morgan
Stanley showing that 22 out of the past 28 years of positive
annual returns for European equities have been followed by a
strong January. 
    Positioning is likely to be more skewed after Friday, when
some 2.9 million winning call bets are set to expire, 76 percent
more than profitable puts. With more call holders potentially
tempted to reinvest their profits, the market could become more
optimistic and even less cushioned for any possible weakness.
    With a relative lack of insurance in place for a move lower,
investors may have less stomach for such a correction and may
sell up sooner than they would if they were more hedged, thus
potentially further increasing any selling pressure.
    The size of any possible correction is hard to estimate
given the uncertainty over when - and whether - it might happen.
    Possible triggers could include a failure to reach a U.S.
budget deal by January - something to which Societe Generale
gives just a 10 percent probability - and any big
disappointments from the next earnings season. 
        
    SHORT HORIZON    
    A sharp reduction in shorts - when investors sell shares
they have borrowed, betting the price will fall so they can buy
them back and repay the loan at a profit - on European indexes
in the past month also points to growing optimism.
    Shares on loan fell 7 percent on the STOXX Europe 600
 and 18 percent on Britain's FTSE 100, according
to stock-lending data firm SunGard Astec Analytics.
    Investors wishing to bet on near-term strength in Europe
could buy a high strike call and sell a low-level one on the
euro zone index, offsetting that with a reverse position on the
U.S. S&P 500, said Vincent Cassot, head of equity
derivatives strategy at Societe Generale.
    However, both the market-expected, or implied, volatility on
euro zone stocks and the demand for options suggest the optimism
is largely for the near term: investors have bought nearly twice
as many puts as calls for December 2013 in the past month. 
    "Our view is that there is some risk looming but it has been
transferred to the longer term, may be one, two, three years,"
SocGen's Cassot said. 

 (Reporting by Toni Vorobyova; Editing by Catherine Evans)
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