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Should Investors Worry About Morgan Stanley?

Emmanuel Dunand | AFP | Getty Images

It's the U.S. financial that speaks with a distinct European accent. At least, that's what investors seem to think about Morgan Stanley.

Shares of the investment giant have dropped 5 percent in two days, as jitters over Cyprus spooked the market and put European tail risk back onto the table. And while banks as a whole have sold off, Morgan Stanley in particular has taken it on the chin.

In fact, perhaps even more troubling than the stock action have been the big purchases of out-of-the-money puts, long-shot bets that the stock will trade much lower.

(Read More: Morgan Stanley 'Confident' About Its New Direction: CEO)

Specifically, several traders have bet that Morgan Stanley shares will fall below $10 by January 2014 or the January 2015 expiration.

The shares closed at $22.39 on Tuesday, having fallen to their lowest level in more than two weeks.

Of course, Morgan Stanley has long been thought of as the bank that stands to lose the most in the case of a European nightmare scenario.

Developments in Cyprus have reignited worries about the euro zone debt crisis, with Cyprus's parliament on Tuesday rejecting a proposed levy on bank deposits as a condition for a 10-billion euro ($13 billion) European bailout.

But is the sell-off in Morgan Stanley shares really justified?

"Absolutely not," says Michael Wong, who covers the name for Morningstar.

"Frankly, I think it's a little unfair for Morgan Stanley to sell off more than other financial institutions," Wong says. "People have mischaracterized the absolute exposure that Morgan Stanley has in Europe, and because of that, they have mistakenly chosen them as the default proxy for troubles in Europe."

Others see it differently.

"When Morgan Stanley sells off on Europe, people always protest, 'They don't own so many bonds.' But that's not the problem," said Enis Taner of RiskReversal.com. "Morgan Stanley is a pure investment bank, and the European banks are big trading counterparties of theirs."

(Read More: Morgan Stanley Swings to Profit, beating Expections)

For that reason, Morgan Stanley is especially sensitive to anything that might hurt those European banks. In a worst-case scenario, Taner says, Morgan Stanley could have to shell out massive sums of money to protect their outstanding trades with stressed European banks.

That could get very expensive very quickly, which might explain the drop in the stock.

But what about those massively bearish options bets?

"What you start to see in these banks is hedge funds buying puts in case the stock goes to zero," Taner explains. "Investors will buy far-out-of-the-money puts as insurance contracts to protect their cash at the bank, or to protect their bond positions. Essentially, what you are seeing is people hedging their tail risk."

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