* Traders expect market to stay range-bound to year-end
* Investors using options to improve their returns
By Sudip Kar-Gupta
LONDON, Oct 18 (Reuters) - Investors betting on European stock markets staying in a tight price range for the rest of the year are turning to specialist options trades to improve their returns.
Demand for such trades has risen on the view that the 2012 stock market rally, driven in the second quarter of the year by central banks’ pledges to inject new stimulus into a weakening global economy, might be over, dealers said.
Uncertainty over the debt problems of Spain and Greece has caused markets to slip from peaks reached in mid-September, and a Reuters poll showed investors expected European share prices to stay in a narrow range in the coming months.
Even a request from Spain for a sovereign bailout would not necessarily shatter the share price paralysis because stock markets had already factored in such an event, the dealers said.
“Nobody is going to make a ton of money in this sort of sideways market without taking the necessary risk,” said Randy Saaf, who runs small U.S. hedge fund AlphaGenius.
In one of the favoured options trades, an investor holding a stock or index sells a “call” option -- essentially a bet an asset will rise -- on that stock or index, typically with a one- to three-month expiry date.
In this “call overwriting” trade, the investor is betting the stock will not rise by enough to trigger the option, allowing him to add the proceeds of selling the call to any share price gains.
Conversely, if the option is triggered, the loss is cushioned by the higher share price.
Deutsche Bank European head of equity derivatives strategy, Simon Carter, said that by repeating this trade over a year, investors could materially e n hance the return on the stock.
“It’s potentially a great source of income. ‘Call overwriting’ becomes far more compelling in a low-growth world,” he said.
Carter added that demand for the trade had been strong, not only from specialist hedge funds but also from mainstream pension funds looking for market-beating returns.
XBZ European equity options broker Mike Turner said clients, such as hedge funds, had also taken up another trade known as a “call butterfly”, which essentially plays on the probability of a stock or index remaining within two price levels.
Under this trade, the investor picks three levels where the index might be in the future. He sells a call option on the one in the centre of the range and buys calls on the others.
As long as the index moves away from the central price but stays within the range, the investor benefits from all three.
Turner said these trades had been used on indexes such as Germany’s DAX or the euro zone blue chip Euro STOXX 50 to try and profit from the sideways trading patterns on those markets.
He said most of those “call butterfly” trades on the DAX involved options due to expire in December, at strike prices of 7,600 and 7,900 points. The DAX closed at 7,395 points on Wednesday.
The trade had also been used on the Euro STOXX 50, with strike prices with a December expiry of 2,700 and 2,900 points. The index stood at 2,570 points at Wednesday’s close.
“People are betting on the market going sideways or grinding slightly higher by then,” said Turner.
Richard Edwards, who runs London trading and analytics firm HED Capital, said such strategies often required bets against the trend of a rising or falling market.
“If you think that a market is in a range, you sell short at the top and go long at the bottom, and you zig-zag your way along the range. You’ll capture more price movement than just sitting long or sitting short,” he said.