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The markets in Europe still haven't shaken off the debt crisis despite the ECB's LTRO. In my previous article Euro: The Currency That Defies Supply and Demand? I had suggested that the EU (EZU) might not be done with its troubles and any strength in their markets would be a result of EUR weakness. Another argument of that article was that the German market (EWG) was outperforming its southern European counterparts, as investors have no motivation to take the extra risk involved in the periphery.

The Italian and Spanish markets are experiencing some accelerated downward pressure, as of this writing. A hit on both of these markets were widely expected by traders, as the underlying reasons of EU's debt crisis haven't been solved by the LTRO. However, what might have changed is, the widely expected market correction in May 2012 might have been pulled forward by a month or so. The markets are very overextended with relatively little fundamental base to build upon and it seems they will have difficulty keeping up the rally until May 2012.

The downward move on Spanish and Italian markets might be the start of a medium-term pull back. Based on that fact, I would like to suggest a trade that has a rather nice risk/return trade-off, in my opinion.

Any trade that involves Europe actually has two risk components: the EUR/USD exchange rate and the actual market itself. Usually these two components are very highly correlated as deterioration in the markets also triggers a loss on the EUR/USD exchange (FXE).

For those of you who want to take advantage of a decrease in both components, I would suggest an option trade on the ETFs iShares MSCI Italy Index Fund (EWI) and iShares MSCI Spain Index Fund (EWP). These are American ETFs and hence their price is affected by both the EUR/USD exchange rate and the underlying index. The implied volatility on these ETFs are still below the volatility levels that we would be experienced if a pullback in the EU markets were to occur, in my opinion. Therefore the options on these ETFs provide a rather inexpensive way to gain exposure to a possible pullback in the EU periphery.

Between to two markets, Spain and Italy, I would suggest playing on Spain if you need to choose. Spain not only has its own problems, but it is also exposed to the Portuguese ones. Spain's underlying fundamental problems are also still widely unresolved. In contrast, Italy is perceived to be on the right track with its reform efforts, which has gained approval from the core EU countries. Spain is also greatly exposed to the construction market, which seems to be a couple of years away from a recovery. Finally, there is a technical factor why Spain is a better choice for a short trade. Shorts have already attacked the Italian market and they have failed as ECB intervened. Having lost a great deal of money on that failed attack, the shorts will likely try their chance with either Spain or Portugal. Italy would definitely get struck as a side-effect, but it wouldn't collapse.

I would also like to give a more specific trade example to play the Spanish market. The expected decline in the mentioned market would be around 10% probably. In addition, let's assume there is a 5% decline in the EUR. Two of those declines combined would take the EWP down to 24.43 based on the ETF value, as of this writing. You can buy the 28 Apr 2012 and May 2012 Puts for $0.30 and $0.95 respectively. If we assume you buy an equal amount of those puts and our decline assumption holds, you should almost quintuple your invested capital and you would break even with even a combined decline of 5% in the EUR and the underlying index. Of course if markets can manage to keep themselves up, you would lose your invested capital. You could put on this trade with 5% of your portfolio for an approximately 21% additional return to your portfolio in two months, including transaction costs and loss to bid/ask spread. That makes it a good risk/return tradeoff, in my opinion. Of course, option trades might not be suitable for your risk appetite, so please consider your own risk and return objectives before putting on any trades.

Please feel free to comment below with your take on the European situation and what other trades could be made to take advantage of the expected sequence of events.

Source: Italy, Spain On The Move: A Good Low-Risk Trade