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High Risk, High Reward Europlays

“Fortune favors the brave.”

Those words were first uttered on board a boat one summer day in the Bay of Naples. A prefect of the Roman Navy named Gaius Plinius Secundus was sailing aboard a light vessel toward the shore where Mount Vesuvius was erupting.

As cinders and debris began falling on the ship, the helmsman urged Gaius Plinius to turn back. But Gaius Plinius was set on rescuing Romans trapped near the volcano so he gave the order to sale into the darkening cloud of smoke. In ancient times, it was widely recalled as an act of extreme heroism.

Investors with high tolerance for risk may have opportunities around the potential collapse of the euro zone that few others can take advantage of. While others concentrate on protecting their assets against a potential massive disruption in financial markets, a modern day Gaius Plinius Secundus might decide to sail a bit closer to the eruption in hopes that boldness will produce fortune.

Here are a few ideas that may be out of bounds for many because of the risks involved. But note: most people would probably be better off taking the path taken by Pliny the Younger, who stayed on the far shore studying rather than join his uncle on the risky rescue mission.

Short Portugal. Yields on the Portuguese 10-year bonds have come way down since they peaked on January 30,of this year. Maitny smart money managers think that there is less risk in Portugal defaulting on its bonds or leaving the euro zone than in other European peripherals. But a disorderly exit in Europe could send down prices on every euro denominated asset that isn’t issued by the German government. Even if you are long term bullish on Portugal, you might consider that the bonds may well be “on sale” at an exit by Greece or Europe.

U.S. Attorney General Eric Holder speaks as during a news conference to announce Medicare Fraud Strike Force law enforcement actions October 4, 2012 at the Justice Department in Washington, DC.
U.S. Attorney General Eric Holder speaks as during a news conference to announce Medicare Fraud Strike Force law enforcement actions October 4, 2012 at the Justice Department in Washington, DC.

Buy Spanish Bank Debt. Let’s say it is Spain that exits the euro zone. This will likely have immediately catastrophic effects on the Spanish financial system. Depositors will attempt to withdraw funds, bond yields will spike, equities will sell off.

But, ultimately, the bonds may be safe. Capital controls will prevent a run on financial assets. Spain will have the flexibility to recapitalize the banks. We saw that bond holders in U.S. financial institutions made out quite well following the bailout.

If another member state of the euro zone exits, one of two scenarios are likely to play out. First, Spain follows and exits shortly afterward. In which case, the trade above pays off. Alternatively, Europe acts to stem defections — by bailing out the Spanish financial system. In which case, owning the bonds of Spanish banks may well be the trade of a lifetime.

Sell Swiss and German equities. A serious slowdown in Europe will hurt Swiss and German exporters. Switzerland, in particular, will have to defend its currency against the possibility of appreciating beyond the point where its exports are competitive. At least for some time, these European powerhouses could see deteriorating economic conditions as their neighbors collapse.

Go Long Volatility in the New Currency. It’s almost a certainty that the new governments will misprice the new currency, setting an exchange rate the market will reject. But its hard to predict whether the currency will move up or down — okay, probably down, but you never know, especially in the early days. So instead put on trades that allow you to profit from the volatility that is almost certain.

Buy Exit Stocks and bonds. When a country devalues its currency and defaults on its debts, outsiders — especially creditors who feel cheated — often predict that economic catastrophe looms. But history doesn’t support this view.

“Dire predictions about economic growth following devaluations are invariably wrong, and most countries quickly recover pre-crisis levels of GDP. If we look at recent devaluations, in almost all cases where countries devalued, they had short, sharp downturns followed by steep, prolonged upturns,” Jonathan Tepper, the Chief Editor of the macroeconomic research group Variant Perception, argues in a recent paper.

If that view is correct, the stock and private debt markets in the devaluing/exiting countries will likely perform very well. Just make sure you don’t take on all the currency risk by buying before the exit. The timing on this one is once you can buy the stocks and bonds with the newly depreciated currency.

Those are your sailing toward Vesuvius trades. Only for the bold.

But keep in mind that its not clear Gaius Plinius Secundus was correct in his assessment of fortune’s favor. He died, apparently from inhaling toxic fumes, without ever returning from the rescue mission. His body wasn’t found until days later, when the soot had finally cleared from the sky.

-By CNBC's John Carney
Follow John on Twitter.

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