Newedge Says Buy Options, Not Shares of Small Caps After Gains

By Gareth Gore

May 21 (Bloomberg) -- Investors should buy call options instead of shares in Dow Jones Euro Stoxx 50 Index small caps after their “stunning” gains relative to the benchmark make them more susceptible to a drop, according to Newedge Group.

Carmaker Renault SA, which has the smallest weighting of the companies on the European benchmark, has surged 139 percent since March 9. The next smallest member, Fortis, has rallied 134 percent during the same period, dwarfing the 35 percent advance in the Euro Stoxx 50 since then.

“Small caps were taken out of limbo territory by investors over the last two months, while the large caps - oil shares for instance - underperformed,” London-based analyst Daniel Roy wrote in a note to clients today. That may leave a “large” risk of a potential downside for the companies, he added.

Investors should buy call options on small cap companies as a “safer” way to participate in any rally in the index after the recent decline in option prices, the brokerage said. Call options give buyers the right, but not the obligation, to buy shares at a pre-agreed price on or before a specific date.

The VStoxx Index, which gauges the price of options on the Euro Stoxx 50, yesterday dropped to its lowest since Lehman Brothers Holdings Inc. filed for bankruptcy last September. The index has declined 26 percent so far this year amid growing optimism the worst of the crisis may be over.

The cost of being wrong in terms of the timing of a rally in small caps may be “very high” after their recent advances relative to the wider index, Roy wrote in the note. “Elasticity and law of gravities playing both ways, the potential downside risk of buying these shares now is large,” he added.

Renault, Fortis, Dutch insurer Aegon NV, French train maker Alstom SA and Telecom Italia SpA are the companies with the smallest weighting on the Euro Stoxx 50.

Options are derivatives, or securities that derive their value from an underlying asset, and can be used to protect against a decline or to speculate on the asset’s future value.

To contact the reporter on this story: Gareth Gore in Madrid ggore1@bloomberg.net.