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European stocks risk post-election setback

European stocks risk falling sharply on Monday given the level of complacency about weekend elections in France and Greece implied by the options markets.

Investors have had some time to get used to the idea that Socialist Francois Hollande will be the next French president and that there will be a backlash against the traditional parties in Greece.

But the risk that the new political landscape could affect national and European policies in a way that investors won’t like may not be fully reflected by the positioning in the equity derivatives market.

“The market is in a very dangerous situation,” said Julien Nebenzahl, strategist at technical analysis firm Day-by-Day.

Investors and traders purchased on Thursday nearly twice as many options that give them the right to buy the Euro STOXX 50 index in May than options that give them the right to sell, Eurex exchange data showed.

The call options that give the holder the right to buy the index at a pre-set price are used to bet stocks will rise while the put options which give them the right to sell are used to bet on, or insure against, a fall in the market.

A ratio measuring the number of put positions compared with the number of calls has fallen to 0.69, its second lowest reading in five months, according to Thomson Reuters Datastream.

Generally, such a low put/call ratio is a sign of upbeat market sentiment.

But given the political and policy risks related to the Greek parliamentary and French presidential elections, such positioning leaves the market vulnerable to setbacks.

That is because investors hold relatively little insurance against a drop in European stock markets and would therefore be likely to rush to sell their cash equity holdings if caught out by unexpected news.

Because “investors are not really worried by the global environment, they are not buying as many puts as we should see given the context we have,” Nebenzahl at Day-by-Day said.

“In the coming weeks we could see a sharp fall in European markets, something like 10 percent or even more. Any bad news, any negative surprise ... would have a very negative effect on the market so we recommend keeping cash, staying liquid.”

The Euro STOXX 50 index is down 1.1 percent in the year to date.

Implied volatility on the index, a crude barometer of investor risk aversion, has been edging up.

But, at 28.28, it is still 7 percent lower than it was on April 23, the day after the first round of French elections put Socialist Francois Hollande in the lead and the Dutch government collapsed over planned austerity measures. Moreover, it has still halved since peaks seen in August 2011.

Those who advise investors say this might be a good time to take out some insurance.

“Given where protection is at the moment, it’s not particularly expensive. It would make sense to buy some protection around these events,” Orrin Sharp-Pierson, equity strategist at BNP Paribas, said.

Analysts at Trading Central, who specialise in studying chart patterns, said implied volatility could rise as high as 35 in the next month or two. That would be compatible with a moderate decline on the Euro STOXX 50.

Any market reaction on Monday is likely to be further exaggerated by a public holiday in Britain. Lower trading volumes mean even smaller trades will have a bigger impact than usual.

“There is a lot of money probably sitting on the sidelines waiting for a trend. It leaves you more exposed to a large move,” said Andy Ash, head of sales at Monument Securities.