Don’t Trade, Invest in the Trading Place

Posted On March 23, 2016 9:17 am

This leading option exchange will benefit from the continued growth in trading of derivative products and is also a takeover target.

The trading landscape has changed dramatically over the two decade. Twenty years ago the big shifts occurred on the investor facing front. Technology provided incredible improvements in access to information, electronic and online trading drove down trading and commission costs. It was a real democratization and coincided with successive bull markets; first the tech bubble and then the housing bubble.

We know they both ended badly but in between it spurred trading volume and fostered the expansion of both existing exchanges and the launch of new trading platforms. And that in turn provided the catalyst for the second big industry transformation; in order to fund system upgrades and expansion, and participate more fully in the boom times the previously ‘not-for-profit’ exchanges decided to become public companies.

The Chicago Mercantile Exchange (CME) had its initial public offering (IPO) in 2002 at $35 a share raising $166 million. Over the next six years the stock, on split-adjusted basis the stock zoomed from around $10 to its 2008 peak of $140, a 1,300% gain. Along the way nearly every other exchange, from the New York Stock Exchange and Nasdaq, to other futures exchanges such as the NY Mercantile Exchange to the Intercontinental (ICE) all had IPOs.

That set the stage for industry consolidation as these now profit oriented companies needed to provide growth to shareholders and scale to fight off upstart trading platforms such as Liquidnet. The mergers spanned the globe with the Deutsche Börse and London Stock Exchange, which has already consolidated the European exchanges, reached across the Atlantic and east into Asia to make alliances and create global footprint.

Below shows a somewhat incomplete list but gives a hint of the consolidation.

Bourse Buyouts

Standing Alone and Growing

Aside from wanting to service an increasingly global and 24 for hour day trading world much of the above merger activity was done to buy growth in the face of flat, or even declining trading volume in basic equity or stock trading. Trading volume on all NYSE issues, which includes all multiply listed shares, saw only 3% average annual growth from 2000 to 2007, and has actually declined by 2% per year since. By contrast, trading in currencies and interest rate products has enjoyed steady high single digit annual increase over the past decade.

But the clear winner for growth has been the explosion in option trading; option volume, which grew by 30% per year from 1995 to 2005, has maintained an average 19% average annual increase over the past 10 years and crossed above 4 billion contracts in 2015. This includes options on stocks, indices, currency, commodity and other derivative products such as volatility.

The Chicago Board of Options Exchange (CBOE) remains the largest option exchange with nearly 28% share of total volume. And while the diversity of its product line helps smooth the bumps as different products enjoy flurries of activity at different moments in time, it is the dominance in the most popular and growing products that makes the CBOE a promising investment opportunity.

The CBOE dominates trading in options on equity products such as S&P 500 Index futures and options on stock ETFs such as SPY and QQQ.

But what has increasingly become the CBOE’s crown jewel is the Volatility Index (VIX) and all the related volatility products.   Trading in VIX futures and options, which launched at the auspicious period just prior to the financial crisis has absolutely exploded with nearly 100% average annual growth over the past five years.

VIX Futures

VIX and VIX futures trade a combined 1.4 billion contracts in 2015 and are on pace to hit 2 billion in 2016. It may fall short as the volatility of January, which caused record trading volume for VIX products, has subsided it should still mark another two years of 35% increase.

Throw in all the volatility related products, there VIX ETFs such as VXX , and VIX-like futures and options on oil, gold and interest rates and trading in volatility will total more than 3 billion contracts in 2016. What’s nice from an investor standpoint is trading volume in these surges when markets are in turmoil or prices fall. In that sense the CBOE shares can act as a hedge to your portfolio without actually trading these products.

Aside from offering a nice diversification across asset sectors, option and derivative trading provide better margins to the exchange than plain vanilla stock trading. This evidenced by the March 9 announcement that the Nasdaq’s will pay $1.2 billion to acquire buy the International Securities Exchange (ISE), the world’s second largest option exchange share of about 15%, from Deutsche Börse, on March 9.

The CBOE has a current market capitalization of $5.3 billion and trades at 24x next year’s earnings so it’s not a cheap on nominal or value basis. But it does have nearly double the market share of the ISE and a monopoly on proprietary assets such as SPX and VIX products. This makes it valuable as both a standalone exchange and a potential takeover target by the larger firms such as ICE or CME.

The stock had a nice rally from its February lows and is now pulling back to important support near the $64 level. This looks like a good risk/reward entry point.

CBOE Charet 3.21.16

The Trade:

The CBOE is set to report earnings at the end of April. I want to make sure I encompass that I and the next earnings report. I’m targeting the purchase of at-the-money call options that expire in September. Specifically;

-Buy September $65 Calls for $3.50 per contract

My expectation is shares could get back to their 52-week high near $72 share giving the calls a minimum value of $7 per contract. That works out to a nifty 100% gain. I’d watch the $62 level as warning flag for managing risk and exiting the trade.

About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.