* Hedge fund managers bet on EADS stock recovery after slump
* "Buy the predator, sell the prey" say some arb traders
* Option volumes signal more positive mood on EADS
* Political, regulatory headaches cloud trade views
By Blaise Robinson and Simon Jessop
PARIS/LONDON, Sept 17 (Reuters) - Bets that a proposed EADS-BAE Systems merger will struggle to be completed or even fail are on the rise, signalling a possible recovery in the recently-hammered shares of EADS, the Airbus parent.
The deal - to create a European aerospace-defence giant with sales of more than 70 billion euros - faces political and regulatory hurdles. There are also shareholder concerns over the structure of the deal.
Hedge fund, merger arbitrage and options market positioning, along with short-selling data and technical charts all point to a bounce for EADS given the scale of the sell-off by institutional investors when tie-up talks were announced.
EADS stock has fallen by almost 14 percent since Wednesday when details of the talks surfaced, while BAE shares are up around 6 percent. EADS was up 1.9 percent on Monday and its UK target down 0.12 percent.
The slide in EADS shares, which wiped out most of its year-to-date gain, has in turn prompted some to bet on a rebound in EADS versus BAE, at least in the short term.
"From a classic merger arbitrage perspective, these stocks are already trading right at the 60-40 (suggested all-share) split," David Noble, Louis Capital Markets event sales trader, said, referring to the expected market capitalisation of the merged entity. "That's ridiculous at this stage of the game."
"Everyone has cut their numbers on EADS, but if there is no deal, or if there's speculation of no deal, you're going to see a pick-up in EADS shares," London-based Noble added.
The scale of the fall in EADS also took it into chart territory that suggests the shares may recover.
The stock's 14-day relative strength index (RSI) is one of several widely-used momentum indicators that have moved into "oversold" territory. It sank to 23.8, its lowest in more than a year. Thirty and below is considered "oversold".
The stock's next target should be 26.6 euros -- the lower band of a gap in the chart opened last Thursday. Above that, the next major resistance is at 27.8 euros -- the higher band of the gap and the 200-day moving average of the share price.
Positioning since the EADS selloff among merger arbitrage traders sceptical of a deal also points to potential EADS outperformance.
"We should have a lot of political noise in the coming days, weeks and months ... we believe there's at least a 50 percent chance the deal will not go through," a Paris-based risk arbitrage trader said.
Instead of the classic merger arbitrage strategy of "buying the prey, selling the predator", a number of traders recommended the reverse, called a Chinese spread in M&A jargon, in which an investor buys shares in "predator" EADS and sells stock in "prey" BAE Systems.
That so-called "pairs trade" is a market-neutral strategy that bets on the gap between the performance of the two assets regardless of the overall market direction.
One hedge fund manager who had taken the bet said they hoped to make a 4 percent return if the deal went through and up to 10 percent if it failed.
Options market data also backed up the more optimistic punt on EADS, although traders said volumes were light.
Data from derivatives market operator Eurex showed the put-to-call ratio on EADS options for December at 0.88, signalling more bets the shares would rise than fall were being laid.
However, while taking a long position on EADS stock seems logical at this point, going short on BAE Systems may be more risky, a Switzerland-based merger arbitrage analyst warned.
"BAE trades at a very low multiple and you don't know if there could be a third party interloper making a bid for BAE."
BAE trades at 8.3 times expected earnings for 2012, compared with 12.9 times for EADS, 15.1 times for Boeing, 9.4 times for U.S. defence firm Northrop Grumman and 9.3 times for its peer General Dynamics.
For those wary of going short on BAE, Louis Capital Markets' Noble suggested the so-called "Texas approach", a merger arbitrage strategy where both shares are bought.
"That way you're exposed to a potential rally in EADS if the bid fails, and you're also exposed to BAE if there's a counterbid, while being hedged both ways," he said - a trade that stock lending data appears to support.
Data from Astec Analytics, a unit of SunGard, showed less than 1 percent of available BAE stock is out on loan, suggesting little expectation the price will fall, while data shows a pick-up in lending of EADS shares, but not enough to signal rising short interest in the stock.
"If anything, there are more people thinking that EADS' share price will suffer than BAE, although it's not a clear signal," said David Lewis, analyst at Astec.
The apparent rise in demand to borrow EADS shares is a false signal, warned Derek Hammond, head of institutional equity sales at Societe Generale, in London.
"Most of the current short interest is coming from the major prime brokers in anticipation of end-client demand which thus far has manifestly failed to materialise."
For some, however, the prospect of political interference from a range of interested parties was too great to risk a bet of any stripe just yet.
"We believe this situation is complex on a political point of view and makes it very difficult to analyse potential outcomes/timetable," said Amit Shabi, partner at Paris-based Bernheim, Dreyfus & Co, which runs merger arbitrage hedge funds.