* Bank launched 5 bln euro rights issue on Monday
* Trading stalls due to technical issues linked to share sale
* Shares rise 40 percent in two days (Adds source on order price limits, comment)
By Silvia Aloisi and Andrea Mandala
MILAN, June 10 (Reuters) - Italian bank Monte dei Paschi's 5 billion euro capital raising caused confusion on the Milan stock exchange on Tuesday, where the bank's shares have jumped 40 percent in two days but have not traded.
Italy's third biggest bank, which has taken two bailouts since 2010, is expected to succeed in raising the cash it needs to repay the government aid and bolster its finances in preparation for a wide-ranging review of European banks.
But the large size of the rights issue, which will not be completed until early next month, has effectively stalled trading in the shares for technical reasons, which have created a big gap between the bid and offer prices.
The cash call is nearly twice the bank's market value of 2.9 billion euros ($3.95 billion). It offers existing shareholders 214 new shares for every five held, at a price of 1 euro each.
The issue will increase the number of tradable Monte dei Paschi shares to around 5.116 billion from 116 million euros.
But the new shares will not be delivered until the end of June at the earliest, when the bulk of the capital raising process is over.
Traders and other financial market sources said the fact that the new shares are not available for several weeks has helped to pump up the share price, but they expect it to fall sharply once the new shares are released.
Speculation in Monte Paschi shares in the run up to the rights issue, as well as other technical factors, have resulted in a flood of buyers when there are relatively few sellers.
Analysts and traders said one element affecting the market were call options - or options to buy Monte dei Paschi shares - being exercised during the rights issue, forcing those who sold them to buy the relevant number of shares on the market.
According to Reuters data, buy orders were for around 17 million shares against around 2,600 shares on offer for most of the session on Tuesday. The bid price on the shares was 2.2160 euros and the offer price was 1.48 euros.
The Italian stock exchange only allowed the shares to trade at the closing bell. They ended the day at 2.2160 euros, 20 percent higher - the maximum percentage change generally allowed by the stock exchange in a single trading session. They had risen by a similar amount on Monday.
Traders said the share price increase was artificial.
"It's a classic short squeeze due to the dilutive nature of the rights issue, there are way more new shares than old ones but the new shares won't be delivered until the third week," the head of a derivatives trading firm in London said.
"It's an embarrassment to be honest," he said, echoing the frustration voiced by many Milan traders who said the Italian Bourse - owned by the London Stock Exchange, should have predicted the problem and taken measures to offset it.
"It's not clear yet how it can be resolved," one trader said. "It's unheard of, there is no justification for shares of a company in the middle of a capital increase not trading and only pricing once a day, even if there are technical issues."
In previous highly-dilutive capital increases, shares were allowed to trade and the price to spiral higher. In the 2012 cash call by insurer Fondiaria-SAI, for example, the shares soared 120 percent on the first day.
This time, the Italian stock exchange and market regulator Consob decided only to allow bids at a price no more than 20 percent higher than the closing level of the previous day, effectively limiting the potential upside, one source close to the situation said.
The Milan Bourse and Consob, which banned short-selling in Monte Paschi shares during the capital increase as is customary in Italy, had no information on Tuesday about when trading might return to normal. They had no further comment.
Traders and finance experts said the jump in Monte Paschi's share price could persuade existing shareholders to take part in the cash call - boosting its chances of success.
Swiss bank UBS is leading a consortium of 23 banks that is underwriting the share issue. UBS declined to provide any immediate comment.
"There are certainly technical factors, but one can only observe that this creates in unsophisticated observers the impression that it is worth exercising the rights," Andrea Resti, finance professor at Milan's Bocconi University, said.
"This is a psychological effect that helps ... the capital increase."
The trading in the rights of existing investors to take part in the share sale was not disrupted. They shed 7.4 percent on Tuesday - after a similar fall on Monday - to 19.92 euros for the right to buy 214 shares. A drop in the rights is not unusual in this kind of transaction as some investors opt out of the cash call.
The price of one euro for the new shares represents a 35.5 percent discount to the theoretical ex-rights share price taking into account the dilutive impact of the cash call, and a 96 percent discount to the previous closing price of around 25 euros. The rights will trade until June 20 on the Milan bourse and can be exercised until June 27. ($1 = 0.7345 Euros) (Addiitonal reporting by Paola Arosio and Valentina Za in Milan and Francesco Canepa in London. Editing by Jane Merriman)