September 30, 2014 / 8:54 AM / 3 years ago

Bank derivatives boom ahead of ECB test results as investors play safe

LONDON (Reuters) - Investors hopeful but not entirely confident that next month’s European bank check will yield positive results are stacking up derivatives positions to balance optimism about the industry against worry over its performance in a faltering economy.

The headquarters of the European Central Bank (ECB) is pictured prior to the bank's monthly news conference in Frankfurt July 3, 2014. REUTERS/Ralph Orlowski

The European Central Bank is expected to publish the outcome of its bank asset quality review on Oct. 26 in a bid to convince investors - after three previous “stress tests” failed to spot subsequent problems - that Europe’s lenders have sifted out their risky holdings and now have enough capital to withstand any more financial crisis-style shocks.

However recent nasty surprises are still vivid. The euro zone banking index fell nearly 17 percent between April and August as poor economic data from Italy, France and even Germany threw into doubt a euro zone recovery while top banks like BNP (BNPP.PA), Lloyds (LLOY.L) and Royal Bank of Scotland (RBS.L) were hit with hefty fines for misconduct ranging from sanctions violations to manipulation of key interest rates. Portugal’s announcement of a 4.9 billion-euro ($6.22 billion) bailout for Banco Espirito Santo BES.LS caused more pain.

With all that in mind, investors are hedging their bets.

As a way of taking a punt without putting much capital at risk, many are turning to call options - which offer the right but no obligation to buy shares at a certain price and time.

Derivatives strategists at JPMorgan, Societe Generale and BNP Paribas have all been advising their clients to bet on a modest rally after the results’ publication.

“Investors ... cannot afford to miss a potential strong rally that could be triggered by this event, but do not always have sufficient conviction to just buy cash equities,” said Davide Silvestrini, head of European equity derivatives strategy at JP Morgan.

Since the summer, interest in banking sector call options has surged: There are currently more open bets on a 9 percent rise on the Euro STOXX banking index .SX7E by December than there are on a roughly equivalent fall, Thomson Reuters data showed. This is an unusual occurrence because investors tend to hedge against a fall rather than a rise in shares.

That reluctance to commit money to bank shares is reflected in the current performance of the Euro STOXX banking equity index - currently 10 percent off its March peak.

But, say some investors, that dip also means the potential for fresh gains if the ECB publishes a positive report.

STAMP OF APPROVAL?

Those expecting a surge in banking stocks are basing their position on the fact that the ECB’s asset quality review (AQR) is likely to confirm that banks have got themselves into shape.

Sources familiar with ECB thinking told Reuters recently that the central bank is likely to say most banks have improved since the crisis abated last year. [ID:nL6N0RP2QK]

That would remove a threat currently hanging over the banks - that of more capital increases, which dilute equity and send shareholders running, pummeling share prices - and instead allow banks to focus again on lending, helping to improve the economy and their own profits.

“Post-AQR you’ll have a sort of stamp of approval coming from the ECB on the banks’ capital levels,” said Gerry Fowler, global head of equity and derivatives strategy at BNP Paribas.

“Even with the fairly consensus view that the stress tests won’t be bad, you could still see the Euro STOXX banking index up 5 percent just because the deluge of data increases transparency.”

Derivatives strategists have been advising clients to take out ‘call spreads’ which typically involve buying a call to be exercised at a price equal to or slightly above current levels, while also selling another call with a higher price, both to cut the cost of the trade and limit potential losses if shares fall.

BNP Paribas recommended buying one December call with strike prices of 155 or 160 points, effectively betting on a rally of at least 6-9 percent, and selling two calls with strikes at 165 or 175 points, or 12 to 19 percent above current levels.

Some warier investors were looking at longer-dated options.

Vincent Cassot, head of equity derivatives strategy at Societe Generale, tipped buying a call with a 150 points strike price, 2 percent above the current level, due to expire in March 2015, financed by selling a call with a 170 points strike.

”If you have the sector going up quickly, then you’re going to still do well, if not, you’re going to have more time with the March 15 expiry,” Cassot said.

Editing by Sophie Walker

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