Spanish Pain, Investor Gain?

Investors who shorted the iShares MSCI Spain Index Fund

over the last few months could have made a nice buck. Now, with Spain's banking problems escalating into a full-blown crisis, investors may be looking for other ways to play the Spanish pain. With Spanish bond yields blowing out to euro-area records, it appears that the situation is going to get worse before it gets better.

Investors would obviously look to short Spanish government bonds. However, this may become risky, as yields move higher for a few reasons. First of all, the European Central Bank can still buy bonds in the open market through its Securities Market Program (SMP). Analysts think that if yields were to reach 7% on the 10-year bond, the ECB would be forced to act to drive yields lower. With yields only 35 basis points away from this level, there isn't a large potential gain to be had should the ECB act. Thus, shorting bonds may be risky from a risk/reward perspective. Shorting bonds may also be risky because of the looming bailout of the banks and the subordination risks of the sovereign debt. Investors who wish to short bonds would be wise to check which laws the bonds were written for; Greece, UK and other foreign-law bonds may end up senior to domestically issued debt. Investors seeking other ideas to capitalize on Spain's deteriorating conditions do not have to look any further than the euro. Trading the EUR/USD via the spot markets or through ETFs,such as the CurrencyShares Euro Trust

, seems like the most obvious derivative play, as weakness in the Iberian peninsula would weaken the currency. Traders should look to short the EUR/USD cross on breaks back into the 1.2540/50 region and target 1.2490 on the downside, for a quick 60 pips gain. Remember to keep stops tight though, as any headline out of Europe could send the pair sharply higher. Another derivative play on Spain is Italy, and traders looking to capitalize on weakness in Spain may consider shorting the iShares MSCI Italy Index

. Italian banks will suffer as contagion fears reign, so shorting Italian stocks may prove profitable for traders. Italian stocks have been hurt in the recent market swoon. However, if traders see contagion spreading to Italy from Spain, it could very well get much uglier. For those not wanting to take the risk out of shorting, another play would be to simply buy the VIX through the VXX ETF

, which tracks the short-term VIX futures. In the last few summer market corrections, the VIX has surged above 39, so it is reasonable to think that if the financial conditions worsen, the VIX will rise. Currently, the VIX is trading near 22, so this represents nearly 100% upside. Investors may be able to get in front of the next wave of negative news by taking advantage of some of the ideas listed above. With the Greek election this weekend and further uncertainty surrounding Spain, there is sure to be volatility for traders coming in the next several trading days. Good luck and good trading.