By Sudip Kar-Gupta
LONDON, Feb 26 (Reuters) - European shares tumbled on Tuesday after an Italian election stalemate threatened a renewal of the euro zone crisis, leading traders to use equity options to bet on a further market fall in coming months.
The pan-European FTSEurofirst 300 index was down 1.1 percent at 1,153.45 points by around midday, while the euro zone's blue-chip Euro STOXX 50 index retreated 2.6 percent to 2,583.25 points.
Italy's FTSE MIB equity index was the worst performing European bourse, slumping 4.6 percent on concerns that the election, which left no party clearly in control of the Italian government, could hamper reforms and drive up its borrowing costs.
Worries about a new flare-up in the euro zone's debt crisis fed through to the bank sector, whose lenders could be hit with new writedowns and bad debts if the region's economy weakens as a result of debt problems in countries such as Italy and Spain.
The STOXX Europe 600 Banking Index was the worst-performing sector, falling 2.7 percent with Italian banks such as Intesa and Unicredit - which own large amounts of Italian government debt - dropping 10 and 8 percent, respectively.
Data from the Eurex exchange showed that investors had snapped up nearly 50 percent more 'put' options due to expire in March on the Euro STOXX 50 than 'calls'. A 'put' is typically used on expectations of a market fall, as opposed to a 'call' option which is used on expectations of a future market rise.
The Eurex data showed that 'put' options expiring in March with strike prices of 2,450 and 2,500 points had been the most popular, implying that investors are betting the index could fall by 5 or more percent by the middle of next month.
Mike Turner, European equity options broker at XBZ Ltd, said clients were extending Euro STOXX 50 'put' options due to expire in March through to April and May to protect themselves against any further moves down over the next month or so.
"There's a thinking that we're heading lower and we'll stay lower for another month or two," said Turner.
The euro zone debt crisis led to a sovereign bailout of Greece and other smaller countries, but Spain is also under pressure over a possible similar bailout, while Italy faces a battle to contain its borrowing costs.
Last summer the European Central Bank pledged new measures to tackle the crisis and protect the euro currency, which enabled stock markets to rally in the second half of the year.
But Spanish foreign minister Jose Manuel Garcia-Margallo said the Italian result was extremely worrying, with Spain's IBEX stock market falling 3 percent.
"Spain will also now come under pressure," said Syz Asset Management's chief economist Fabrizio Quirighetti, who added that European equity markets could potentially fall some 5 percent this week.
Despite the post-Italian election fall, XBZ's Turner said the stock market decline was more of a "correction, not a sell-off", with the FTSEurofirst 300 still up around 20 percent from its 2012 low of 948.17 points.
Michel Juvet, chief investment officer at Swiss bank Bordier, said he had sold off equity positions last week on expectations that equity markets could retreat over Italian election problems.
"We cut the equity allocations last week across the board. Everything was pointing towards a correction. I see no rush to buy Italian assets at this moment," he said.
Clairinvest fund manager Ion-Marc Valahu said he had been buying the Euro STOXX Volatility (VSTOXX) index on expectations that the Italian problems would increase volatility on stock markets in the near term.
The VSTOXX index surged 19.5 percent to touch new 2013 highs on Tuesday, and BTIG European equity strategist Nick Xanders recommended investors to buy such volatility options, with the VSTOXX still below its 2012 high of 38.31 points.
"Volatility is still not that expensive," wrote Xanders.