European equity options traders eye Q1 fall then later rally

* Traders take options betting on gradual rise higher

* Put spreads could be used for any Q1 market fall

* Call options would work for market grinding up over 2014

By Sudip Kar-Gupta

LONDON, Jan 17 (Reuters) - Expectations of solid gains for European equities this year mask a growing rush of bets on a weak first quarter, with investors piling into the options market to protect themselves.

Goldman Sachs (NYSE: GS-PB - news) warned this week of the risk of a 10 percent pull-back at some point this year in U.S stocks, which have already hit record highs.

In Europe, after lacklustre updates from several mid-sized U.S companies this week, investors have started to position for weak first-quarter earnings that could trigger a short-term fall in shares.

Nevertheless, investors say the longer-term upwards path for European shares remains intact.

The region's economy is slowly recovering while the European Central Bank (ECB) has kept interest rates at a record low and stands ready to take action should deflation threaten the fragile economic upturn.

SteppenWolf Capital chief investment officer Phoebus Theologites said this environment favoured options trades which allow investors to bet on a first-quarter fall, followed by a recovery bringing the market back on an even keel and ready to resume its move higher.

"You want to protect your downside to a certain degree in case we have a substantial pull-back in the first quarter, and you are comfortable with capping your upside gains," he said.

Theologites backed options to bet on a modest market retreat by March and a recovery to above current levels by June, as did Francois Savary, chief investment officer at Swiss bank Reyl.

"It would form a useful investment strategy," Savary said.

DOWN IN MARCH, UP IN JUNE

Such trades could help maximise investors' returns in a year when most expect overall equity market gains to slow from 2013's pace. The euro zone's blue-chip share index, the EuroSTOXX 50 , rose 18 pct last year.

Savary said there was a risk of an equity downturn if European companies' first quarter earnings missed market expectations, given downbeat updates from companies such as retailers Carrefour (Paris: FR0000120172 - news) and Ahold (Amsterdam: AH.AS - news) this week.

This could see the Euro STOXX 50, currently trading around 3,160 points, fall some 7 percent down to 2,900 points before recovering to end 2014 at 3,400 points, he said.

Both Savary and Theologites said this scenario could be played through "put" options - bets the Euro STOXX 50 could fall into the 2,850-3,050 point range in March.

Data from the Eurex exchange's website showed demand for "put" options betting on a fall in March has crept up by around 5 percent since the end of 2013 to reach 1.9 million contracts.

Mike Turner, European equity options broker at XBZ Ltd, said customers had bought "put spreads" this week to protect against any such stock market fall, in a trade aimed at betting on the market retreating to, but not beyond, a certain level - such as 2,850 on the Euro STOXX index.

Traders could at the same time take out a "call" option to bet on the Euro STOXX 50 then recovering to reach the 3,275 point level by June, said SteppenWolf's Theologites.

These two bets would provide winning returns in both March and June, if the market fell to the expected level in March before then recovering to hit the expected target in June.

JP Morgan (Other OTC: JPYYL - news) 's equity derivative strategists this week backed "call spreads" to bet on only a slow grind higher on Spain's IBEX and Italy's FTSE MIB equity index.

"What you are doing is betting that the market will not take off and rally massively and that, if it tanks, it will not tank massively," said SteppenWolf Capital's Theologites.