Playing Both Sides Of The Eurozone Fence By Pairing Volatility With Germany

Includes: EWG, VXX
by: Daniel Sckolnik

I find hope in the darkest of days, and focus in the brightest. I do not judge the universe.

- Dalai Lama

The pattern exhibited by Wall Street on Monday is one that seems to be right out of the movie, Groundhog Day. For those who may have missed this comical but perceptive musing on the nature of eternal recurrence, one man gets to repeat the same day again and again, until, against all odds, he gets it right.

The part investors may be missing at the moment is the aspect of getting it right.

"Eurozone Day" keeps on repeating, with bad news followed by the inevitable round of new proposals that, in turn, are followed closely by an upswing in optimism. The optimism lasts until reality sets in, the reality being that the whole sovereign debt problem of the region may simply be a reflection of a fatally flawed union. Bank liquidity issues may receive the Band-Aid treatment, national budgetary belts may get tightened, but until some vehicle of shared credit is established, such as some version of a eurobond, all fixes are temporary.

In case anyone missed it, Greece held an election, and quite a few people came. The result of the vote, considered to be "pro-bailout" in nature, was one that was trumpeted as an indication that the Greeks are willing to do what it takes to stay within the confines of the euro. So, it was a de facto vote for what passes as the status quo, meaning that the market had no need to panic. Accordingly, early results in Asia, then Europe then Wall Street seemed to indicate that investors were, indeed, somewhat pleased at the Greek election results.

However, by the end of the day, the Dow, rarely above water intra-day, ended down 25 points, though the S&P 500 did manage to eke out a small win. Not quite the stuff that signifies a ringing endorsement of investor confidence.

At this point, Greece is hardly more than a canary in a coal mine. One look at Monday's rising yield on Spain's 10-year Treasury note, again topping the 7% mark, reveals a level of borrowing costs the Spanish government won't be able to repay. Yields on Italian bonds also returned to pre-LTRO heights, hovering above 6%, which is likely unsustainable as well. Taken together, they provide a clear indication that the noise about how the "right" results in the Greek election would prop up the market was really nothing more than aural static.

For the next scene in 'Eurozone Day', watch how some new promise from this week's G-20 meeting will once more get the market giddy with upside potential. Or the one after that, where Bernanke and Company announce a sequel to "Operation Twist". But as before, initial gains will probably fade away in short order.

There's always the possibility of a surprise hit that actually gains some traction in the markets, perhaps something along the lines of a concerted effort by the world's major central banks to enact a coordinated round of stimulus. However, judging by past history, the level of cooperation such an action would require might take quite a while to muster. The patient may be unresponsive by the time that remedy becomes available.

And, while it might seem like this seeming perpetual round of new promises and broken expectations is eternal, the clock is ticking loudly, and the alarm may ring pretty soon.

In the meantime, a position may be taken for a trade that plays both sides of the fence simultaneously. Here is a pairs trade that balances a swift change in sentiment to the upside with the ability to handle a deep drop should current solutions once again be revealed as inadequate.

On the long side of the trade, you could use EWG (MSCI Germany Index Fund), which tracks the performance of the German equity market. It gained 3.4% year-to-date (YTD).

The short side of this particular trade would be VXX, which tracks the S&P 500 VIX Short-Term Futures Index. Should the Bulls resume control of the market, then VXX, a derivative of the VIX, known as "the fear gauge", will drop as well. On the other hand, if the eurozone resumes its negative ride, then the VXX should rise steeply, mirroring increased volatility.

Remember that this trade requires one to go long VXX, as well as going long EWG. While this might seem counter-intuitive for a pairs trade, remember, the VXX, like the VIX, generally goes up as the equity market goes down, and vice versa.

Disclosure: I am long the VIX via options on futures contracts.

Disclaimer: This article is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into account their personal financial circumstances in acting on any rankings or stock selections provided by Daniel Sckolnik nor Sabrient. Neither Daniel Sckolnik nor Sabrient makes any representations that the techniques used in its rankings or selections will result in or guarantee profits in trading. Trading involves risk, including possible loss of principal and other losses, and past performance is no indication of future results.

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