How to Play the Euro

 | Nov 02, 2011 | 10:30 AM EDT
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What a difference a couple of days makes. After riding high on one of the most powerful rallies in recent financial memory, global markets have fallen off a cliff.

Only a week ago, European leaders had agreed on a new 130 billion euro ($180 billion) bailout package for Greece, and a semi-coerced 50% "voluntary" haircut on Greek bonds. But yesterday, Greek Prime Minister Papandreou threw a spanner in the works, calling for a referendum on whether Greece will accept his government's strategy of slashing public spending and raising taxes in return for loans to help bail out his country. Apparently, Papandreou went completely off book, as he failed to consult even his finance minister before announcing plans for referendum.

Papandreou is clearly doubling down in his political future. On the one hand, the Greeks do approve the measures, his government's efforts will have gained a new level of legitimacy. On the other, if Greek voters vote no, it will spell the end of his stint as Prime Minister. Greece will default on its debts, exit the euro and switch to a "new drachma."

So what's on tap if Greek voters call Papandreou's bluff?

European banks will take major losses in their bond portfolios. Its economies will tip back into recession. Although Greece's economy is only about the size of Rhode Island's, the most serious impact will be financial contagion. Once Greece exits the euro, the precedent for similar action in Portugal, Spain and even Italy will be in place. And that spells bad news for the currency.

So, the question is: How you can profit?

Well, you can short U.S.-listed Greek ADRs such as the National Bank of Greece SA (NBG) or Coca-Cola Hellenic Bottling Company S.A. (CCH) and NBG. And you can short whatever European banks you can get your hands on.

But the real Black Swan bet is against the euro. If the Greeks do vote no on the referendum, it will signal the breakup of the euro, and the currency will fall through the floor on the news. Option prices will shoot through the roof on spikes in volatility. So the best way to profit from this is an out-of-the-money call on ProShares UltraShort Euro (EUO) -- a 2x leveraged bet against the daily price movement against the euro. Since the Greek referendum -- assuming it occurs -- will happen over the next two months, take a look at February 2012 $20 calls on EUO.

On Sept. 16, 1992, George Soros made $1 billion by betting that the U.K. would exit the European Exchange Rate Mechanism (EERM). Greece exiting the euro would be similar event. If the euro drops 10% on the same day that Greece exits the euro, EUO would drop 20%. Throw in the leveraged impact of a call option, and you'll have your own personal "George Soros" moment.

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