This week's rocky start for European stocks is driving equity traders to seek protection against any further sharp declines as concerns over China weigh on markets. Despite being touted yet again as one of the most favoured investment plays of the year, euro equities have made their weakest start to the year in decades with losses so far of almost 6 percent, prompting a scramble in options markets to hedge against further losses of over 3 percent this month.
Traders and investors said the weak near-term outlook was spurring demand for "put" options, essentially bets on a market falling in future which give an investor the right to sell. Fears of a slowdown in China, the world's second-biggest economy and a major export market for European companies, intensified this week after Beijing allowed the yuan's devaluation to accelerate.
Slumps in Chinese stocks also hit world markets, with Goldman Sachs estimating that this week represented the worst start to a year for European stocks since the early 1970s. Markets in China stabilised on Friday, but many traders remained braced for more market weakness in the first quarter. "Buying protection should indeed be one of the key themes for Q1," said Ankit Gheedia, equity derivatives strategist at BNP Paribas.
"There is a clear lack of any positive news for equities while continued commodity and manufacturing sector weakness combined with Chinese yuan depreciation is increasing deflationary pressures," he added.
POSSIBLE REBOUND LATER IN YEAR? Thomson Reuters Datastream data shows a steady climb in the Eurex put/call ratio - a ratio measuring the amount of negative "put" options versus "call" options that are plays on a market rising - since the start of January. (bit.ly/1SClcIc) UBS' equity derivatives team said January 'put' options with a strike price of 3,000 points on the Euro STOXX 50 index were among the most popular among investors.
That would imply a bet that the Euro STOXX 50 index would fall at least 3 percent from current levels down to 3,000 points by later this month. Paul Gleeson, head of Arcanum Asset Management, added he was considering similar trades, although he would look to hedge by also betting on a market recovery later in 2016. Some investors said the European Central Bank's (ECB) programme of economic stimulus measures would provide a cushion for European stocks and allow for the prospect of stocks climbing back up later in 2016.
Societe Generale strategists on Friday still backed European stocks at a general level, but recommended avoiding German shares due to their exposure to China. One idea from UBS' team was to sell Euro STOXX "put" options due to mature in February with a strike price of 3,000 points in order to fund buying "call" options maturing in June in the 3,300-3,500 point range. This would essentially represent a bet that the Euro STOXX could still fall down to 3,000 points over the coming month, but could also get back up to 3,500 points by June.
BNP Paribas' Gheedia noted similar trades being taken out by investors, but added that the risk of more weakness in China, along with the chance that the ECB may not provide further stimulus straight away, meant stocks remained vulnerable. "There could be further downside to Chinese-linked stocks, as well as the risk that the ECB could stay on pause for the first half of the year," he said.
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