How To Play The Italian Referendum

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On the 4th of December, Italians will vote in a referendum on the future of their country.

Concerns about the potential Italian exit from the European Union put pressure on the euro which is speculated to reach parity with the U.S. dollar.

As in the case of the Brexit vote and the U.S. presidential election, nobody knows what will be the result.

Likewise, presumably the best way how to play this event is to go long volatility instead of making a directional bet.

The currency pair Euro - U.S. dollar is a hot candidate.

At the beginning of the next month, Italians will vote on constitutional changes proposed by the current Prime Minister Matteo Renzi. The ultimate goal of the reform is to limit the power of the Senate and to amend powers of other administrative and governing entities. If voters reject the proposal, Mr. Renzi - the leader of centre-left Democratic party - is likely to resign which would be a negative consequence for the European integrity.

As final polls before the blackout period showed that Renzi's proposal is headed for a defeat, speculations over the euro-dollar parity came back to the forefront of financial media and the euro dropped to the lowest levels since December last year.

Source: Bloomberg

Even though it may look like the outcome of the referendum is clear now, the official results of the referendum will not be known until at least the first weekend in December. As we have already witnessed several times this year, the official results tend to vary from public opinion polls quite frequently and therefore one should consider these factors carefully when making investment decisions.

The reason why opinion polls are usually highly inaccurate is that they suffer from several statistical biases including sample selection biases and time-period biases at the top of the list. As I have already written in my previous SA article, probably the most serious issue is the fact that a sample consisting of 1000 respondents is simply not large enough to make any inferences about the whole population of eligible voters.

Undoubtedly, there are many ways how to profit from the event. One can take a directional bet using some of the popular exchange-traded products such as the UltraShort Euro ETF (NYSEARCA:EUO), the Market Vectors Double Short Euro ETN (NYSEARCA:DRR) or the iShares MSCI Italy Capped ETF (NYSEARCA:EWI), but most people certainly agree that the best bets are those which will make a profit regardless of the referendum outcome.

Based on my options trading platform, should the EUR/USD currency pair move 1.65% upwards or downwards from a market strike price, a long straddle strategy will be in the money at the expiration date two weeks after the purchase. To get a better insight how likely this scenario might be, let's bring to light some statistics.

Following the U.S. presidential election day, the euro closed 1.07% lower against the greenback and presently extended losses up to 4.04%. According to forex volatility calculator, the year-to-date daily volatility for the EUR/USD pair is currently 0.86%. In other words, should the market reaction to the Italian referendum be at least half the market reaction to the U.S. presidential election result, the option strategy is very likely to be in the money at some point before its expiration.

Lastly, this heavily dramatized voting event seems to be just a beginning of a series of events, which will take place in the first half of the following year. With rise of populism across the world, investors will be tensely watching German, Dutch and French and other European elections next year. Any political escalations stemming from these events could further pressure the European currency. We will see what the future holds, but for now, as the popular saying reads: 'Be prepared for the worst, but hope for the best.'

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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