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Upcoming Election Could Trigger a Move That Makes Traders Up to 150%

Italians will go to the polls on Feb.24-25. Unlike in the United States, poll results cannot be published in the two weeks leading up to an election in Italy, so uncertainty hangs over the results, and that uncertainty hangs over the euro as well.

Although European countries adopted a common currency, their political and national economies are far from united in a clearly defined common European vision. The Guardian, a British newspaper, shows that there are five possible outcomes for the Italian election, ranging from Greek-style economic turmoil to a relatively stable government.

This election is very important since Italy is in a recession that has lasted for six quarters and appears to be deepening. The new government may be able to take steps toward recovery, or, like any government, could make missteps that inadvertently damage the economy. Italy is also facing a debt problem and a government budget deficit that the new government will have to tackle. In many ways, these are the same kind of headlines we've seen from Greece, Spain and other European countries.

In the run-up to the election, Italian stocks have been falling. U.S. traders can use the iShares MSCI Italy (NYSE: EWI) to gain exposure to the country.

This ETF was one of the strongest performers in the U.S. stock market until just a few weeks ago, gaining more than 54% between its July low and the end of January. But EWI has fallen about 9% this month, and the ETF is now near a key technical support level.

Italy Fund EWI Chart

EWI fell below the 20-week moving average this week, which is the midpoint of the Bollinger Bands. Stochastics is bearish but far from oversold, indicating additional downside is possible. Moving Average Convergence/Divergence (MACD) just turned bearish, indicating the downside move could be starting.

Relative strength (RS), shown at the bottom of the chart, has collapsed from 98 to only 5 in four weeks. The RS rank shows how a stock or ETF is performing relative to the rest of the market. An RS rank of 98 showed EWI was outperforming 98% of all other stocks and ETFs over the past six months. The current rank of 5 means EWI is only outperforming 5% of the market. Looked at another way, 95% of the market offers a better buying opportunity than EWI does.

Technical weakness and political uncertainty create a short trade opportunity, and being short EWI seems to be the best way to trade this election.

Inverse ETFs are often considered to be an alternative to short positions, but they often fail to meet their objectives. The only inverse fund for European equities appears to be ProShares UltraShort MSCI Europe Index Fund (NYSE: EPV). Like many leveraged, inverse funds, EPV has a strong downward bias and does not seem to be a suitable substitute for shorting Italy.

The chart below shows that EPV has lost significant value while iShares S&P Europe 350 Index (NYSE: IEV) has been relatively flat.

EPV vs IEV Chart

Many traders prefer not to sell stocks short because there is a great deal of risk in a short position. Rather than selling EWI short, traders could buy put options to benefit from a down move.

Italy's election may not lead to a clear outcome immediately, and it could take days or weeks for traders to fully understand what the new government will bring. Because it will take time to assess the election, traders should consider using options that expire in June to allow for the possibility that perceptions will change.

Given the weakness of EWI and the technical picture, we believe it should drop to $11.50, the lower Bollinger Band on the weekly chart, and eventually retest the July lows below $10.

June puts with a strike price of $14 offer a potential way to profit from this drop. They are currently trading at about $1.60 and will be profitable at expiration only if EWI is below $12.40 ($14 strike price - $1.60 premium). If EWI falls to the initial $11.50 price target, the options would be worth at least $2.50 and deliver a profit of 56%. If EWI fell to $10, these options would be worth at least $4 and offer a potential profit of about 150%.

This is a trade that will benefit from a return to the crisis atmosphere that has defined Europe for so much of the past few years. It seems likely that an election will trigger a renewed sense of crisis and we may see that process begin in the next week as Italians go to the polls.

Recommended Trade Setups:

-- Sell EWI short at the market price
-- Set stop-loss at $13.50
-- Set initial price target at $11.50 for a potential 10% gain in 2-4 months
-- Set secondary price target at $10 for a potential 22% gain in 6 months

-- Buy EWI June 14 Puts at $1.80 or less
-- Set stop-loss at $1
-- Set initial price target at $2.50 for a potential 39% gain in 4 months