CORRECTED-European investors seize on cheap options to bet on US debt deal
(Corrects banker's title in fifth paragraph of story first filed on Friday)
* Investors snap up calls to bet on stock market rally
* Default risk pushed back to November expiry
* Demand to protect higher in U.S. than Europe
By Alistair Smout
LONDON, Oct 11 (Reuters) - European investors are piling into cheap one-month option bets on a short-term U.S. debt deal, while loading up on protection for November in case the money runs out.
European index options expire on Friday, Oct. 18, a day after the deadline for Washington to raise the debt limit to ensure the United States avoids a default. Deadlock over the budget issue has weighed on stocks in Europe and a resolution could provide a boost to the cash market, leaving many call options to buy the market in profit.
Rising demand for one-month call options in Europe reflects growing confidence among investors that, with or without a deal, the United States will get through this month without defaulting on its debt. But what happens after that is also making them nervous.
While demand for October puts on the Euro STOXX 50 , to protect against a fall in the share index, has also increased, by 14 percent since the partial U.S. government shutdown began at the start of this month, demand for November puts has surged by 65 percent.
"The Oct. 17 deadline is not a hard deadline as such; there is cash and ways to keep things going really until the Nov. 1 Social Security payment is due. Therefore November should be the hedging bucket of choice, not October," Rory Hill, EMEA co-head of equity derivatives at Citi, said.
"As a result, investors want long October calls and against this long November or December puts."
Volatility indexes reflect demand to buy options to insure against cash market moves but they can also be traded as an asset in their own right, using futures and other derivatives.
The U.S. budget impasse has led the main gauge of U.S. stock volatility, the VIX, to decouple from Europe's gauge, the VSTOXX, as demand to protect U.S. holdings outstripped demand to hedge against falling European markets.
As part of that move, the VIX hit a four-month high this week while Europe's VSTOXX only chalked up a new six-week peak, meaning the cost of options to buy or sell the Euro STOXX 50 was relatively cheaper.
The ratio of puts and calls on the Euro STOXX 50 dropped to 1.145 on Thursday, its lowest since Sept. 17 and down sharply from 2.137 the previous day, indicating a greater appetite for bets on a near-term market spike.
On Thursday, activity in October calls almost tripled compared to Wednesday after the Republicans floated a plan to extend the government's borrowing authority beyond the Oct. 17 deadline, while demand for puts remained broadly steady.
Meanwhile, those October calls are starting to come good. The Euro STOXX 50 jumped 1.7 percent on Thursday to a fresh 2-1/2 year high on signs U.S. politicians were discussing raising the debt ceiling temporarily.
Since Wednesday, 39 percent of calls held by investors on the European index were pushed into "in the money" territory, where the market price is such that the option is worth exercising.
Over a quarter of open positions in calls are at yet higher levels of 3,000 and above, meaning investors are betting on further rises for the Euro STOXX 50 before next week's expiry.
The index was trading at around 2,973.70 on Friday.
Andy Ash, head of trading at Monument Securities, said Euro STOXX 50 October calls that kick in at 3,000 points or FTSE 100 calls that profit if the index hits 6,550 look good value. The FTSE 100 was at 6,485.26 on Friday.
EUROPE HOLDING UP
European options' relative cheapness has been helped by demand in the United States to protect holdings by buying puts on U.S. stocks, which has driven the VIX higher.
Hill at Citi said that recent rises in the VSTOXX were a result of people trading the divergence between the VSTOXX and the VIX, rather than because people feared for their European holdings.
"The spread between European and U.S. vols (volatility indexes) looks attractive so there has been buying of European vols to enter the spread," Hill said.
Uncertainty about the U.S. budget situation was also encouraging investors to shift to European equities, which have lagged U.S. stocks this year.
The pan-European FTSEurofirst 300 is up 10 percent year to date, compared to the S&P 500's 18 percent gain.
"There's a rotation out of U.S. equities into Europe, (and) the noise around the debt ceiling has accelerated money coming out of the U.S. given the strong performance year-to-date." (Additional reporting by Toni Vorobyova and Blaise Robinson; Editing by Simon Jessop and Susan Fenton)
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