Traders are buying up 'call' options betting on a gradual move higher in European stock markets, as expectations grow of new stimulus measures from the European Central Bank. The ratio measuring the number of negative 'put' options versus bullish 'call' options on the euro zone's bluechip Euro STOXX 50 index - the most liquid European market for options traders - has dropped sharply in the past three weeks, to 0.93 currently from 2.45 on August 8.
A ratio below 1 usually signals investors are bullish, while a ratio above 1.5 signals they are turning cautious, buying 'puts' as a hedge for their equity portfolios in case of a market sell-off. Comments by ECB President Mario Draghi in late August sparked market bets that the central bank is preparing to pump more liquidity into the system, possibly via purchases of government or corporate bonds, a measure known as quantitative easing (QE), to reinvigorate the stuttering euro zone economy and stave off the risk of deflation.
"Don't fight the ECB," Saxo Bank trader Pierre Martin said. "The mood is quite positive after Draghi's comments which confirmed that the bank is determined to fight deflation." After a strong start to 2014, Europe's stock market rally started to fizzle out in June, hit by mounting concerns about the region's weak economic recovery and risks of deflation. The Euro STOXX 50 is now up just 2.5 percent this year, having lost 4 percent since hitting 3,325.50 points in June, its highest level in around six years.
The conflict in Ukraine, which has prompted Europe to impose sanctions on its third-biggest trade partner Russia, has further dented Europe's faltering economic recovery. This backdrop has raised the likelihood of new stimulus measures from the ECB. Sources from within the central bank told Reuters last week that new action at its meeting this Thursday was unlikely but not impossible, and that the barrier to QE was still "very high".
While most market participants do not expect the ECB to take major easing steps this week, further measures are considered a matter of 'when' and not 'if', in the face of risks to euro zone growth posed by low inflation and the Ukraine conflict. There was a similar rush to buy 'calls' - particularly on euro zone banking stocks - last November following a surprise interest rate cut by the ECB, as traders bet the sector would benefit from the central bank's ultra-loose monetary policy.
The STOXX euro zone banking index surged 20 percent in the following five months. Phoebus Theologites, chief investment officer at SteppenWolf Capital, said he would buy Euro STOXX 'call' options for early next year since he did not expect the full impact of any new ECB measures to be felt until the first quarter of 2015. "We will buy longer-dated Euro STOXX 50 calls, as we believe it will take six to nine months for any trickle-down effects of QE to be felt," Theologites said.
Barclays derivatives strategists also backed using a 'call spread' strategy on European banking stocks. Banks are expected to outperform on any QE measure from the ECB since they can borrow money from the central bank at practically zero percent and then lend it at a slightly higher rate for a profit. The call spread trade involves two options exercisable at prices above the current spot level. The investor buys a call option, which gives the right to buy the index, at the lower price, and sells a second option, that effectively requires the investor to sell, at the higher price - essentially betting on only a slow move higher in the market. The idea of European stock markets moving only gradually higher on any new ECB action was also supported by Paul Gleeson, who heads Arcanum Asset Management.