MILAN (Reuters) - Shares in Italy's third-biggest lender Banca Monte dei Paschi di Siena (BMPS.MI) rose sharply on Friday in heavy volumes, with traders citing short-covering and an Italian bond market recovery.
At 1609 GMT daily traded volumes were about 5 times average daily volumes with around 5.8 percent of capital traded.
Shares were up 12.3 percent at 0.26 euros while the European banking index .SX7P was up 0.5 percent.
"There is an enormous short on the stock, about 5.5 percent of capital, and traders are covering the position," one market source said.
MPS is the most heavily shorted stock on Italy's FTSE MIB .FTMIB index, according to Markit data.
The data showed shares worth around 6 percent of the bank's market capitalisation were out on loan, corresponding to 77 percent of the stock available to be borrowed, as of the market close on Jan 2.
Short sellers borrow securities with a view to selling them and buying them back at a lower price before returning them to the lender.
Two Milan-based traders said the spread between Italian 10-year bonds and their German equivalent had fallen, making the Italian market more interesting for investors.
"Monte Paschi has taken a bit of a beating with the euro zone crisis and there's a lot of ground for the stock to recoup," he said.
The spread between Italian 10-year BTPs and German 10-year Bunds has narrowed to its lowest level since August 2011.
A London-based trader said there were some rumours circulating of an impending government buyout of the bank but added with general elections due in February this was very improbable.
"The rally is more likely due to the large short base in MPS and the Italian bond market rally," he said.
Another trader said the mark-to-market loss Monte Paschi had on assets for sale had been reduced thanks to the tightening of the bond spread and a spike in the swap rate, which would free up capital.
All this helped the bank since it reduced the likelihood and size of any rights issue or government bailout, the trader added.
Last year MPS was forced to request state aid after it failed to meet tougher capital requirements set by the European Banking Authority.
Under the scheme the bank will issue 3.9 billion euros (3.18 billion pounds) of bonds to the treasury.
A costly 2007 acquisition of smaller peer Antonveneta and vast holdings of Italian government bonds have strained MPS's capital base.
In December Standard & Poor's became the second credit ratings agency to cut MPS to 'junk' status, saying planned state aid may not be enough to stop its capital and funding position from worsening.
On Thursday a source told Reuters banks will get more time to build up cash buffers to protect against market shocks.