How to Profit From Italy

Italy is next on the chopping block.

I’ve been saying it for a long time, but the Euro is in big trouble. Long term, it will fail. In the intermediate term, we’ll see countries like Greece, Italy, Portugal and Spain thrash around on the ground like gaffed catfish.

Even Europeans won’t deny that they’re in trouble anymore – and yet, there’s always the smidgen of hope that they’ll find a way to turn it around somehow. I too am holding out hope that Spain will invent a perpetual motion machine to create unlimited amounts of energy at no cost. Or maybe Italy will figure out how to turn corruption into gold.

But I’m not wasting any money on these pipedreams.

Eventually, Europe will improve, but it will probably be without the Euro.

In the meantime, the misguided hope about the Euro is crashing up against the harsh rocky shores of math.

Italy won’t "figure" its way out of this mess. They’re past the point of no return for Debt-to-GDP ratios, and Italian bonds recently popped to over 7% yields. We’ve seen what happens to Euro-zone countries when they breach 7%.

Time after time, the 7% levee releases a wave of higher and higher rates:

Italy is in big trouble. And the best way to profit from this mess is to go short Italian bond prices. (Bonds 101: when yields rise, prices fall.)

The easiest way to short Italian bonds is to sell shares of the PowerShares DB Italian Treasury Bond ETN (NYSE: ITLY).

Or you can sell shares of the Powershares DB 3X Italian Treasury Bond ETN (NYSE: ITLT). Note that the 3X note is leveraged. Every 1% decrease in Italian bond prices will mean a 3% gain – and vice-versa – a 1% rise means a 3% fall.

ETNs (Exchange Traded Notes) are similar to ETFs (Exchange Traded Funds) but differ in some respects. Both can be bought and sold just like a stock, but the main difference is that Notes are issued by financial institutions as actual instruments of debt.

They’re like bonds in that regard – and they exactly track their underlying assets.

Whereas ETFs are just securities that may or may not exactly track the underlying asset. They call it "tracking error."

The only potential downside to an ETN is credit risk. Since ETNs are debt obligations (in this case of Deutsche Bank AG, London Branch), there’s a risk that the issuer could go belly up and be unable to redeem their notes.

That’s honestly a pretty minute risk, but it’s one you should be aware of. And, of course, there are some different tax implications for ETFs vs. ETNs.

Okay, there’s another risk to shorting these ETNs, but it’s one we can mitigate by pairing this short-side bet with a long-side bet.

I suggest buying shares of a gold ETF to use as a counterbalance to this trade. My long term bet is that gold will rise AND Italian bond prices will fall.

But if bond prices don’t fall, then the Euro will remain strong relative to the dollar – which could be a double whammy for you when you want to cover your short position.

Holding gold in an ETF in equal proportion to your short position will hedge you somewhat in the event that the Euro rallies against the dollar.

I’m not a fan of holding the SPDR Gold Trust (NYSE: GLD) – even for an intermediate trade. If you want to execute this trade, or even if you’re just looking for a more trustworthy exchange traded gold investment for your portfolio, I suggest looking into the Sprott Physical Gold Trust ETV (NYSE: PHYS).

Like ETNs, ETVs (Exchange Traded Vehicles) differ slightly from ETFs. They’re basically notes that have no maturity or coupon (unlike a bond) and are secured by real assets. The idea is that they actually lay claim to allocated and audited gold.

So to recap this trade, using $1,000 as an example.

Sell to open $1,000 worth of PowerShares DB Italian Treasury Bond ETN (NYSE: ITLY).

Buy to open $1,000 worth of Sprott Physical Gold Trust ETV (NYSE: PHYS).

To close this trade out, I would look for a 50% gain in the short position on ITLY. Then you can buy the shares back to close.

Use a 25% stop-loss on the short position, and sell your gold position to cover if necessary.

If you have any questions, please don’t hesitate to drop me a line at [email protected].

Good investing,

Kevin McElroy
Resource Prospector

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