Summary According to data released Friday, Brazil’s economy has entered a recession. The country has been plagued by economic and political turmoil recently. The 2x inverse Brazil ETF BZQ had the highest potential return of any ETF in our universe on Friday. We present a way an investor can be positioned to capture BZQ’s potential return while getting paid to limit its downside risk. Dark Days For Dilma In a recent article about Donald Trump’s new development in Brazil (“Trump Hotel Goes Up, And His Latino Views Barely Raise Eyebrows”), the New York Times noted that, in an interview with the Brazilian magazine Vega last year, the real estate mogul was asked if he’d met with Dilma Rousseff. “No,” Trump replied, “who is he?” The Times informs readers not in on the joke that Ms. Rousseff is, of course, a woman, and the president of Brazil. But if Trump had asked that question to his Brazilian interviewers today, they might have answered that she is also possibly the least popular politician in the country. According to a Reuters article published earlier this month (“Brazil Leader’s Popularity Sinks in Political Crisis: Poll”), Rousseff had an 8% approval rating, in part due to the corruption scandal at the state-owned oil company Petrobras (NYSE: PBR ), which has prompted calls for her impeachment, and in part due to the “worst economic downturn in 25 years” in Brazil. Brazil Enters Recession Rousseff received more bad news on Friday, as official figures showed the Brazilian economy had contracted 1.9% in the second quarter, as reported by BBC News (“Brazil’s economy enters recession”). BBC News also reported that Brazil’s first quarter GDP had been revised downward to -0.7%, from an initial estimate of -0.2%. The official figures probably came as no surprise to Brazilians, as the BBC elaborated: Most people have already been feeling the economic downturn long before today’s figures were out. Unemployment has risen rabidly while inflation was over 12 months is running above 9% – twice the government’s target. More worryingly, analysts believe growth might not return until 2017. Gloomy Outlook From Goldman Sachs Monday brought more potential bad news for the Brazilian economy, as Goldman Sachs lowered its GDP forecast for China, which is Brazil’s largest export market (buying 19% of Brazil’s exports, per the CIA World Factbook ), as CNBC reported (“Goldman takes a knife to China GDP forecasts”): The bank on Monday marked down its 2016, 2017 and 2018 projections to 6.4 percent, 6.1 percent and 5.8 percent, respectively from 6.7 percent, 6.5 percent and 6.2 percent, previously. Government Ineffectiveness Economic weakness in its largest trading partner, combined with a recession at home, would be challenging for any government, let alone one whose leader’s approval ratings are in the single digits. But Brazil’s government showed a worrying sign of ineffectiveness recently, in a trial run for the much-anticipated 2016 Summer Olympics. The World Junior Rowing Championships, held earlier this summer in the same waters in Rio de Janeiro where next year’s Olympic rowing events will be held, were marred by pollution (AP via NY Post: “US rowing team has vomiting, diarrhea after event at filthy Brazil lake”), despite tests going back to March “showing dangerously high levels of viruses from sewage in all Olympic venues.” Investors may wonder how well a government that couldn’t keep the sewage out of its showcase city’s waters during an international athletic competition will be able to handle its current economic challenges. Betting Against Brazil Given Brazil’s current economic and political challenges, and its sensitivity to economic weakness in China, some investors may consider betting against Brazilian stocks. One way to do that would be by buying the ProShares UltraShort MSCI Capped ETF (NYSEARCA: BZQ ), which seeks results corresponding to twice the inverse of the performance of the MSCI Brazil 25/50 Index. That index , which is designed to measure broad-based equity performance in Brazil, includes among its top holdings several Brazilian stocks that also trade in the U.S.: in addition to Petrobras, it includes Itau Unibanco (NYSE: ITUB ), Banco Bradesco (NYSE: BBD ), and Vale (NYSE: VALE ). The “Capped” in the name of the ETF refers to a methodology the index uses to keep any one stock from dominating the index due to its market cap weighting. As of Friday, BZQ was 1st among ETFs and 32nd among all securities in Portfolio Armor ‘s daily ranking by potential return. Every trading day, Portfolio Armor uses an analysis of historical prices as well as option market sentiment to calculate potential returns, which are its high-end estimates of how a security might perform over the next six months. In a previous article (“Backtesting The Hedged Portfolio Method”), we went into a bit more detail about how we tested that ranking system, and tested the performance of hedged portfolios as well. When it creates hedged portfolios, Portfolio Armor is agnostic about whether a security is a stock, ETF, or inverse ETF. Instead, it goes by each security’s potential return, net of hedging costs. BZQ probably wouldn’t have made the cut on Friday, based on its net potential return, but investors who want to buy it as a bet against Brazil can use Portfolio Armor’s hedging tool to find an optimal hedge for it. Adding Downside Protection To BZQ One way to add downside protection is with an optimal collar. A detailed explanation of optimal collars is available here , but, to summarize, a collar is a strategy in which an investor buys a put option, which gives him the right to sell a security for a specified price (the strike price) before a specified date (the expiration date), and, at the same time, sells a call option, which gives another investor the right to buy the security from him at a higher strike price, by the same expiration date. The proceeds from selling the call option offset at least some of the cost of buying the put option. An optimal collar is a collar that will give you the level of protection you want at the lowest price, while not capping your possible upside by more than you specify. Since you are capping your possible upside when using a collar, it can make sense to set that cap at your estimate of the security’s potential return, so, in a bullish scenario, your security doesn’t get called away before you capture that potential return. Since we calculated a 13% potential return for BZQ, we’ll use that as our cap, but, if you feel that, based on the bad news out of Brazil, BZQ could go higher over the next six months, you could enter a higher number for the cap. The other piece of information we’ll need to input here, in addition to the ticker symbol and the number of shares to hedge, is the “threshold”: that’s our term for the maximum decline in the value of the position that an investor is willing to risk. Since that’s based on an individual’s risk tolerance, it will of course vary based on the risk tolerances of individual investors. For the purposes of this example, we’ll use 13% as the threshold as well as the cap. You could use this same process with different values, but, in general, the lower your cap percentage and the higher your threshold percentage, the less expensive it will be for you to hedge An Optimal Collar to Hedge BZQ This was the optimal collar, as of Friday’s close, to hedge 1000 shares of BZQ against a greater than 13% drop before mid-February, while capping the investor’s potential upside at 13%. As you can see in the first part of the image above, the cost of the put leg of this collar was $19,500, or 14.78% of position value. But as you can see below, the income generated from selling the call leg of the collar was $20,500, or 15.54% of position value. So the net cost of this optimal collar was negative, meaning an investor would have collected more for selling the calls than he paid for buying the puts. 1 Essentially, he would be getting paid to hedge. 1 To be conservative, this optimal collar shows the puts being purchased at their ask price, and the calls being sold at their bid price. In practice, an investor can often buy the puts for less (i.e., at some point between the bid and ask prices) and sell the calls for more (again, at some point between the bid and ask). So the actual cost of opening this collar would have likely been less (i.e., an investor would have likely collected more than $1000 when opening this hedge). Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.