In gambling it’s known that the house has the best odds. This futures exchange acts as the house, taking a fee with every transaction. It has an economic moat and if currency and interest rate trading volume resumes its profits could surge. The recent decline offers a buying opportunity.

The CME Group (CME), was at the forefront of exchange consolidation, as the parent Chicago Mercantile Exchange gobbled up the NYMEX, the Chicago Board of Trade partnered with both regional and international exchanges. The range of products across various asset classes include; interest rates, equity indexes, foreign exchange, energy, agricultural commodities, and metals.

Trading trading volume in stocks has been actually declined over the past 10 years and become spread out over various exchanges and “dark pools”. By contrast volume for futures contracts based on currencies, interest rates and commodities and options has shown steady double digit growth over the past decade.

While further consolidation could occur the CME now has the dominate position in these financial products. Like any marketplace, achieving a critical mass of buyers and sellers becomes self reinforcing. At this point the CME’s business has the economic moat that Warren Buffett looks for companies when making an investment.

Collecting the VIG 

The CME collects fee for every transaction. In its latest earnings reported on April 30^th showed that clearing and transaction fees grew 8.6% year over year to $708.2 million, accounting for about 84% of the total revenue. Additionally, revenues from market data and information services increased 9.6% to $98 million. Revenues from access and communication fees rose 4.4% to $21.3 million.   Thanks to its near monopoly on it saw profit margins expand 200 basis points to a robust 36%. All told the company posted profits of $0.98 per share, an 18% increase over the year ago period.

The company’s average daily volume jumped 10% year over year to 15 million contracts in the reported quarter. The improvement was led by higher contracts across all asset classes and across North America and Europe. Notably, international volumes grew about 50%, primarily contributing to volumes accretion. The surge in trading volume was driven by wild currency fluctuations, increased need for commodity hedges especially in the energy complex. While trading volume for the month of April was down from the year ago period I’d expect central bank meddling and increased commodity activity to continue to the trend for increased trading volume.

We are also heading into the busy summer season for products such as corn and soybeans. In fact, in April trading volume in agricultural products jumped 11% over the year ago period. If there is a hot dry summer there could be another surge in price and trading activity.

The CME recently announced it will shutter its physical trading floors for futures as the “open outcry” had dwindled to just 1% of trading volume. As a former floor trader the news marked the end of an era, but as a shareholder I like the reduced overhead and lower costs associated with electronic trading. As a side note, most of the option pits will remain open and manned by humans as some of those transactions need to be more actively shopped around.

Risks Exists

While the CME reaps profits by accommodating others peoples forays into the risky world of trading, its business itself in not without its own external risks. The main issue might come in the form of regulation. On the one hand the desire to create more transparency for products such as interest rate swaps could bring new products to the exchange.   On the other hand, increased scrutiny could result in rules that reduce trading volume.

The recent news that a single trader caused the May 2010 flash crash through the act of “spoofing” the S&P 500 futures has shown bright light on the CME’s own oversight and business practices.   The exchange could not only tighter regulation but also litigation and fines. Those types of external risks are hard to quantify and may be part of the explanation for the sell off over the prior month.

But the recent earnings report seems to have reminded investors what a unique and profitable business the CME operates. The stock jumped some 4% following the report and we now have an identifiable support level near the $88-$90 level.

The Trade:

I want to keep the trade simply with the outright purchase of calls with an expiration that will include at least one more earnings report, the summer growing season and the next few Fed and Central bank meetings.  The call options I’m targeting are:

Buy the September $40 calls for $4.00 per contract.

My ultimate price target is for shares to head back to the $100 level but I would look to take partial profits if the value of the calls doubles to $8 at any point prior to the September 18^th expiration.

Even though this is a limited risk position I would use a close below $87 as a stop loss for exiting the position and minimizing the loss.