Roll-up, roll-up. This will be a shocker…

Remember the ‘Sarkozy trade’?

Last year, Nicolas Sarkozy pointed out that European banks could make serious profits by taking out cheap loans from the European Central Bank (ECB) and investing the money in the region’s government bonds. And European banks really took his advice to heart. Billions have been poured into Italian and Spanish debt since then. And the ‘Sarkozy trade’ has been one of the most popular trades of the year.

Here at The Right Side we couldn’t quite understand, or should I say believe this, farcical European Ponzi scheme. And we were right – it’s already falling apart. And there could be devastating consequences for European banks in the months ahead.

How does that affect us? Well there are ways to prosper in these tumultuous markets.

Today, I’ll go over three of our recent trading ideas; and how we’re getting on in the light of today’s European troubles. And I’ll point out exactly what I’m doing to prepare for the very dangerous banking crisis that’s coming.

One giant Ponzi scheme in action

Let’s start by breaking down exactly how the ‘Sarkozy trade’ works…

Basically, the ECB gives a load of rotten European banks some cheap money (interest is set at just 1%). The banks then go out and buy dodgy eurozone sovereign debt, which pays them, say, 5% interest. Thus the banks look like they’re making good money (which is what it’s all about, isn’t it?). And we also get a bid put under those dodgy Spanish, Portuguese and Italian government bonds. Everyone’s a winner.

But it couldn’t last.

Now, a mere four months into the plan and it’s starting to fall apart. The price of Spanish and Italian bonds is, once again, falling like a stone. Investors such as the Norwegian petroleum fund (as we discussed a few weeks back) have been delighted to dump their European bonds on these muppet banks.

Anyway, now that the price is going down again things are arguably even worse for the European banks involved. They’re now facing losses on this euro-disaster paper. As I said at the time: “Remember, these guys are buying the bonds for a carry trade – maybe they make 5% a year. But what good is a 5% profit if the value of your bonds get cut in half (or worse, as has been the case with Greece)?”

The International Monetary Fund (the IMF) can sense trouble ahead. They’ve asked members to pony up some cash and get the funds in place before disaster strikes.

Osborne did his bit for the cause. He said the UK will be good for another £10bn. Most of the rest of the world put their hands in their pockets too. Christine Lagarde and her team have got some $400bn of pledges in place.

Though she’s said that this money isn’t earmarked for any particular issue, this has ‘Euro bail-out’ written all over it.

The euro crisis is getting bigger and more dangerous by the day. The way it’s being managed is destroying wealth and sucking in fresh cash to replace it. And while the authoritarians refuse to allow the weaker members out of the euro currency area, things are only going to get worse. That’s always been my view – and I’m sticking to it.

I’ve been looking for ways to protect and prosper, despite what’s going on.

Three great trades to consider

One of the most obvious ways to profit from a member of the currency zone leaving was a spread bet on exactly that. And that bet was offered by a company called WorldSpreads. Unfortunately, WorldSpreads went bust. And apart from a load of hassle in getting my funds back, it’s left me without exposure to what I think was a cracking little wager.

But I’ve got a few other irons in the fire…

Another trade I talked about was a punt on the ‘return of volatility’ – that is, go long the VIX with a spread bet.

In March, the VIX had settled down to the mid-teens area and I suggested that it was only a matter of time before the fear gauge would break out again.

Volitility S&P 500 (VIX) chart 

Source: Yahoo!

And it did. The April contract broke briefly to the mid-twenties over Easter. And if you had a limit order to sell (or you monitor your bets closely), you may have made a good profit.

But overall, this has been a difficult bet. I warned readers that we’d probably see a loss before we booked a profit. And unless you booked your profit while the going was good, then losses are more likely to have come your way.

I’m going to go into this bet in a bit more detail soon, as there are complications. Specifically, the costs of roll-over. We’ll see how we can try to limit these costs.

My favourite trade on the crisis in Europe

In the meantime, a simpler bet and one I’m still quite keen on is the short on the banking sector.

The banks have had a fairly decent run of it since the ECB started cooking the books towards the end of last year. But by my reckoning, it’s all unravelling now. There could be serious trouble ahead for the banks as the markets continue to dump the bonds of the weaker euro nations.

If you don’t like the idea of spread betting – and generally putting your money down to profit from carnage in the markets, then there is another way…

Go to cash.

Now, I’m not for one moment suggesting that readers liquidate their portfolios – there are some good value investments out there. But I would suggest that a decent 25% cash allocation is a great idea.

The markets have remained remarkably resilient despite the headwinds emanating from Europe. The FTSE has kept to its now long-established trading range between 5,500 and 6,000. In fact, we’re right in the middle, trading around 5,750.

As far as I can see, we’re going to face a European banking crisis. The IMF has seen the future and has started preparing for it. And I have too.

For my part I’m long the VIX, short the banks and still sitting on a sizeable slug of cash.

Of course I haven’t forgotten about gold. But that’s a longer-term trade. In the event of serious trouble, I think you can expect gold to take a hit along with most other things… except for the three trades I just mentioned, that is.

Any other ideas, if so, then why not discuss them below.

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  • John

    For me spread betting is a tad too risky so I use ETFs and ETNs that attempt to track the VIX instead. There are a variety of them, long, short and leveraged. The caveat with them is that they are not a perfect fit, there is slippage, so they are not a buy and hold. Also, some can be a little wild and unpredictable; take a look at TVIX and what it did in late March. My rules are don’t buy unless the VIX is below 16 or above 30, don’t bet the farm and use as insurance rather than a get rich scheme. And always remember your judgement might be right but you could still loose money because of slippage. However, if you view the world as I do that it increasingly looks like an asylum run by its patients then playing the VIX has another advantage. It can help you sleep at night.

  • Catenaccio

    Conservative Portfolio A

    (a) 65% ishares International G7 Government Bond ETF – because if/when problems flight to $ & yen likely

    (b) 18% db X Trackers Short Euro Banks ETF – because now is not time to be long equities except with banked profits &/or cost averaging & there might be systemic crisis

    (c) 17% £ cash ready to invest long equities (with sale proceeds (b)) on 21%, 35% & 55% downdrafts

    Conservative Portfolio B

    100% $ money market because Dow at over 90% all time nominal so waiting pullback

    Conservative Portfolio C

    (a) 38% ishares International G7 Government Bond ETF

    (b) 16% German bund ETF – if Germany quits € it’s currency rises

    (c) 16% $ Treasuries ETF

    (d) 21% ishares Barclays Capital € Corporate Bonds ex-Financials

    (e) 9% ishares $ Corporate Bond

    Conservative Portfolio D

    100% emerging markets funds & one natural resources fund by investment of fixed amount every month

  • Anthony

    If you want to try trading the VIX, and use the IG Index, use their default stochastic (5 3 3) to guide you and get in and out accordingly. Confirm with the Williams %, R again using the default setting of 14, if you want. You can see that right now it’s a buy and you may even get lower if you can keep an eye on it. If not, try a limit order a bit below last night’s close.

    Good luck!

  • Steve

    Another idea on the volatility theme: when the VIX is low and things seem too calm, short the miners. It is a cleaner trade than long VIX.

  • Anthony

    You are making a good point there. The only thing in favor of the VIX is that it covers all sorts of eventualities. But I wouldn’t just buy and hold – the rollovers each month are likely to cost you. You have to trade this one actively; with the miners short you can take a more laid-back attitude.

  • Steve

    Ah, hindsight. Turns out that a covered warrant put on Antofagasta (‘SR45’, 15/06/12 £8) placed on 26/04/12 would now be up 88%. Time to take profits and leave. Bengt, what about an article on covered warrants? As a short-term (carefully watched) play, they have the advantage of having a known max possible loss, and yes it might go. But for a small amount it might be an idea. Eg a silver call today when silver prices fell. It is the time-decay feature that is the issue.