Options Trading: Invest in the Trading Place First
By: Steve Smith
Today, we’re looking at a leading option exchange, one that will benefit from increased volatility and a swing back to more actively managed investing. Good options trading requires paying close attention not just to the market, but to institutions like this one.
We’ve recently discussed how the spike in volatility in the beginning of February, which caused the implosion of VIX related ETPs, was probably a prelude to the market entering a higher volatility environment, or more accurately, a return to normal after years of artificially low volatility.
We also discussed how higher volatility will lead to more trading opportunities in specific names. Today, I suggest that the Chicago Board of Options Exchange (CBOE), the world’s largest options exchange, is itself a great buying opportunity.
First, a little background on the evolution of trading, the exchanges in general, and the CBOE specifically.
The trading landscape has changed dramatically over the past two decades. Twenty years ago, big shifts occurred on the investor’s front. Technology provided incredible improvements in access to information, and electronic and online trading drove down trading and commission costs. It was a real democratization, and it 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, 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. The Deutsche Börse and London Stock Exchange, which had already consolidated the European exchanges, reached across the Atlantic and east into Asia to make alliances and create a global footprint.
Below we have a somewhat incomplete list, but it gives a hint of the scale of the consolidation.
Standing Alone and Growing
Aside from wanting to service an increasingly global and 24/7 trading world, much of the above merger activity had another motive: 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 multiple-listed shares, saw only 3% average annual growth from 2000 to 2007, and has actually declined by 2% per year since then. 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 options 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 5 billion contracts in 2017. 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 options trading 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 options trading on equity products, such as S&P 500 Index futures and options on stock ETFs, such as SPY and QQQ.
The VIX Tricks
What had 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.
And trading volume continued to increase, even as volatility declined and selling premium became a favored income generation play.
The huge success of the VIX-related products had been a blessing for the CBOE’s share price helping to propel it from $64 in early 2016 to a high of $140 at the end of 2017; a 118% gain over the 2-year period.
But with the ‘volapocalypse’, that blessing became a curse, as investors grew worried that not only would trading volume in these products decline, but the VIX-based funds and CBOE itself might come under regulatory scrutiny or be subject to lawsuits.
As the VIX became the center of the February correction, shares of the CBOE tumbled as much as 30 percent, hitting a low of $96 per share at one point following what was an otherwise solid earnings report on Feb. 9th.
The stock had a sharp snap back, leaving a bullish island reversal, and has since settled above solid support at the $110 level.
This is great risk/reward entry point to establish a bullish position.
While the game of selling volatility might be over, I believe trading volume in the VIX products and Index ETFs and individual stocks will actually increase, as overall market volatility returns to a more normal, and higher, level.
We know the CBOE will post record-setting volume for February, and I expect this rise in activity will continue through the next few months. All that’s left now is the options trading.
I’m going to buy a vertical spread which in which the strike I own is in-the-money. Specifically, I’ll buy the April 105 call and sell the April 120 calls for a net debit of $6.00 for the spread.
Here is the risk graph of the position.
As you can see, with shares currently trading right around $111 the position already has nearly $6 of intrinsic value, meaning it will not suffer from time decay.
With width between strike $15 the position can deliver a an $9 or 150% gain if shares are above $120 at the April expiration. That’s a nice trade on the trading place.
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.
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