European stocks were higher around midday on Tuesday, reversing a sharp two-day slide and resuming their six-week rally on renewed hopes for a Greek debt deal, and as investors cheered the approval of a new euro zone budget discipline pact.

Gains were capped, however, by mounting tension surrounding Portugal's debt troubles, with the country's two-year bond yields hitting a euro-era record above 21 percent.

At 1200 GMT the FTSEurofirst 300 index of top European shares was up 0.9 percent at 1,039.22 points, on track to record a gain of about 3.8 percent on the month, while the euro zone's blue chip Euro STOXX 50 index was up 1.1 percent at 2,429.78 points, set to post a gain of about 4.8 percent in January.

Shares in the oil sector regained ground after a 5 percent drop over the past three weeks, rallying along with crude oil prices on supply worries.

BP was up 2.9 percent, CGG Veritas up 2.5 percent and Maurel et Prom up 2.5 percent.

Late on Monday euro zone leaders agreed to a German-inspired pact for stricter budget discipline, a move eagerly greeted by the European Central Bank.

UPTREND CHANNEL INTACT

Also improving the mood, Greek Prime Minister Lucas Papademos said negotiators had made significant progress in talks to reach a restructuring deal with creditors on the country's debt and avoid a chaotic default, with the aim of a definitive agreement by the end of this week.

Although the euro zone is struggling to reconcile austerity with growth, investors seem to regain confidence after the new pact, while technically the trend is still bullish for stocks with the uptrend channel intact, said Franklin Pichard, director at Barclays France.

Despite losing nearly 3 percent in the past two sessions, the Euro STOXX 50 managed to stay above 2.400 points on Monday, which represents the lower band of an upward trend channel started in late November.

Around Europe, UK's FTSE 100 index was up 1 percent, Germany's DAX index up 1 percent, and France's CAC 40 up 1.3 percent.

The Euro STOXX 50 volatility index, Europe's yardstick of investor sentiment known as the VSTOXX, was down 3.4 percent at 26, easing after a sharp bounce on Monday.

TIME TO BUY VOLATILITY

The recent drop in risk aversion has created a good entry point to set up new long volatility hedging positions, Societe Generale Head of Equity Derivatives Strategy Vincent Cassot said.

Volatility, especially the VIX, has become quite cheap. Concerns over the outlook for the U.S. economy are resurfacing and we're expecting disappointment in macro data in the first quarter, so for investors looking for a hedge against a drop in equities, it's time to buy volatility.

Cassot recommends buying S&P 500 variance swap June 2012 at 23.4 percent, or buy the ETF S&P VIX Futures Enhanced Roll index, an exchange-traded fund that tracks the VIX, to get a long exposure to VIX futures with a limited carry cost.

On the euro zone front, where Societe Generale strategists expect a short technical recession in the first half followed by sluggish growth in the second half, the bank's strategists see the Euro STOXX 50 retreating to 2,100 points in the first quarter, and to 1,700 points in the second quarter, which should send the VSTOXX bouncing between 25 and 40.

Cassot recommends a risk reversal strategy of buying two June-2012 1,950 puts and selling one 2,500 call.

PORTUGAL NEXT?

A risk reversal strategy is a hedge strategy which protects against a drop in stock prices but limits the profits that can be made from a rally in prices.

Jitters over Portugal, seen as the potential next domino in the euro zone crisis, were rising on Tuesday, with the country's benchmark PSI 20 index up 0.4 percent, underperforming European peers.

So far this year, the index is down 3.2 percent while the Euro STOXX 50 is up 4.9 percent and Germany's DAX is up 10.3 percent over the same period.

The next question on the horizon is Portugal, which seems likely to be the next potential hazard for the European Union, Rebecca O'Keeffe, head of investment at Interactive Investor, said.

The likelihood of default for Portuguese bonds is high; the credit swaps market is now pricing in a 72 percent chance of default for Portuguese bonds over the next five years.