Last Tuesday, CBOE reported earnings of $0.56 per share on $157.9 million in revenue -- increases of 14% and 11%, respectively. Concerns over margins and the balance sheet subsequently sent the stock down, but this represents a buying opportunity as growth potential remains robust.
Stock trading has trended lower over the past decade, but option volumes have grown by 5% or more in eight of the last 10 years.
In the first quarter, the CBOE accounted for 29.5% of all options traded, up from 27.9% in Q4 2013 and 26.9% in Q1 2013. Average daily volume escalated 29% year-over-year to 5.62 million, and total volume increased an impressive 31% to 342.8 million.
However, revenue per contract declined 13% due to an increase in volume-based incentives to gain share in lower-margin multiple-exchange-listed options. The balance sheet also took a small hit as cash and assets declined while liabilities increased, leading to a 7.3% fall in operating cash flow.
The CBOE has three product lines: equity options, index options, and Volatility S&P 500 (INDEXCBOE:VIX) futures and options.
Equity option trading includes ETFs such as the SPDR S&P 500 ETF Trust (NYSEARCA:SPY). Volume grew 25% per year between 1995 and 2005, but it has since flattened to around 3% annual growth. But factors like a push into overseas markets, which could expand trading hours, and the growing popularity of weekly options should help grow the business.
And don't dismiss the impact that stock splits in popular high-priced names like Google (NASDAQ:GOOG) and Apple (NASDAQ:AAPL) are 7-for-1. The lower price of stocks and related options boosts volume. If other companies like Priceline (NASDAQ:PCLN) and Amazon.com (NASDAQ:AMZN) follow suit, this could have a meaningful increase in trading volume.
Index options like those based on the S&P 500 (INDEXSP:.INX) and related futures are enjoying steady 5%-8% growth and also offer higher margins thanks to their proprietary nature, and higher notional value relative to ETFs like SPY. The CBOE is actively promoting their use to institutional clients like pension and hedge funds, and it's also gaining traction in Asia.
By focusing on institutional clients that produce steady, growing volumes, the CBOE is becoming less vulnerable to the changing moods of retail traders.
But the real golden goose is the VIX and its related products. Since VIX futures and related options were launched in 2004, trading volume has increased by 20% or more each year. And during the financial crisis, volume surged.
They're also doing well now. In the first quarter, VIX options volume averaged 774,000 contracts per day, up 22% year-over-year. Average daily volume in VIX futures was nearly 203,000 contracts, up 33% from last year.
Ed Tilly, the CEO of CBOE, feels they're still in the early innings of a multidecade growth trend for volatility products.
On last week's conference call, he discussed (albeit in a somewhat wonky way) how portfolio managers across all asset classes are using VIX futures and options for hedging purposes:
Tapping into the $50 trillion fixed-income market could be another real game-changer. The CBOE is working with the CME Group (NASDAQ:CME), the leading bond and currency exchange, to bring to market a volatility index based on the NYSE Current 10-Year US Treasury (INDEXNYSEGIS:AXTEN). The CBOE hopes to first launch a futures contract by fall, which would then be followed by options contract based on the futures.
It's helpful to think in terms of vega when sizing the growing volatility market. Vega refers to how the price of an option can move in response to a 1% change in its implied volatility. Trading in VIX contracts now averages between $200 million and $250 million in vega daily. This is roughly 10 times the vega traded through OTC vol swaps, and about one-and-a-half to two times the daily vega traded on the listed S&P 500 Index (INDEXCBOE:SPX) options. Anyone who trades in options or manages a portfolio has volatility exposure. VIX futures and options clearly have become the preferred means for managing that volatility, but we're still in the early stages of growing that marketplace.
Another area that shows promise is in the CBOE Short-Term Volatility Index (INDEXCBOE:VXST), which I discussed in a prior article.
Tilly acknowledged the product is off to a slower start than hoped for, but he remains optimistic that it will gain traction over time.
Since it's a distinctive new product, as opposed to a simple extension of the VIX, the large liquidity providers need some time to get up to speed. The CBOE is also working with issuers of exchange-traded products to develop trading vehicles similar to the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX).
Tilly has also not ruled out adding weekly options to the existing VIX listings.
Other underutilized index volatility products such as the CBOE Nasdaq 100 Volatility (INDEXCBOE:VXN) and CBOE Russell 2000 Volatility Index (INDEXCBOE:RVX) could also gain traction over time.
At the $50 level, CBOE trades at 18 times next year's earnings, which is relatively attractive given its projected 12% earnings growth of the next five years. And thus, the business of trading looks quite good here.
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