Easiest way to profit from the options boom

More investors are embracing this type of trading, lifting the market leader to a 60% gain in 2013.

By StreetAuthority Aug 28, 2013 5:50PM
Couple in Home Office © Radius Images, Radius Images, Getty ImagesBy Michael Vodicka

One of the few certainties in the market is that investors will always search for new ways to profit. And there is one strategy that continues to gain popularity.

That's because it enables investors to make money regardless if stocks go up or down. It also provides the potential for investors to score big gains with very little risk.

I'm talking about options. In response to market volatility and uncertainty in the past four years, options strategies continue to gain popularity with both institutional and individual investors.

While that has been beneficial to leading financial exchanges such as CME Group (CME) and Intercontinental Exchange (ICE) that carry options contracts, there is another financial exchange that offers unmatched exposure to growth in options trading volume.

The Chicago Board of Options Exchange (CBOE) is the undisputed leader in the domestic options market, boasting 28% market share while offering options on equities, equity indexes and exchange-traded funds (ETFs). Founded in the early 1970s, the company went public just three years ago, cashing in on the trend of financial exchanges going public.

Much like the stocks of other financial exchanges, CBOE has been surging in 2013, with shares up 61% on the year. Take a look at the big gain below.

But the CBOE is different than the other publicly traded financial exchanges. As an options specialist, the CBOE is the purest play on the options market. That places the exchange in a unique position to cash in on the growing popularity of options and increased market volatility.

And that's exactly what is happening. The CBOE continues to see impressive results from two of its most important proprietary contracts.

The first is its VIX (volatility index) contract, with both futures and options trading volume exploding in the past year.

July trading data showed that VIX futures volume was up 53% from last year, while VIX options volume was up 36%. That has VIX futures volume up 99% on the year from 2012, already breaking 2012's volume record in the first eight months of the year. The growing popularity of the CBOE's VIX complex is a powerful engine of growth -- as traders continue to search for more opportunities to speculate on volatility and investors hedge unwanted portfolio risk.

Looking to capitalize on the big popularity spike in VIX futures and options, the CBOE is on schedule to extend VIX futures trading by 45 minutes from its current closing time in September. Phase 2 of the initiative will enable its European clients to trade during regular domestic hours.

The CBOE is also seeing impressive gains with a new line of weekly contracts linked to its high volume and extremely popular S&P 500 (SPX) contract. Through July, trading volume in the weekly SPX contracts was up 147% from last year, now accounting for 25% of total SPX revenue as opposed to just 15% in 2012 and 9% in 2011. CBOE has noted that growing interest from retail investors has fueled the popularity of the weekly expirations, and has plans to launch a new daily contract that should provide stimulus for additional volume and revenue growth.

The recent string of earnings growth has strengthened the CBOE's financial profile. It has cash and equivalents of $208 million with no long-term debt. That led CBOE to increase its dividend by 20% last year to 18 cents, yielding 1.4%. It will also support additional shareholder value, with $100 million remaining on the board's $200 million share repurchase program.

The CBOE could also be an acquisition or merger target. The financial exchange industry has gone through a massive wave of consolidation in the past five years that is still in play. The CBOE's options business would be a highly attractive diversification strategy for an international futures or equity exchange.

The encouraging outlook has the consensus estimate calling for 19% earnings growth in 2013, 16% earnings growth in 2014 and 13% annual earnings growth in the next five years.

Risks to consider: CBOE has been surging in 2013, with shares up 61% in the past seven months. Although the valuation still looks reasonable, that gain has not been accompanied by equal earnings or projected earnings growth. A pullback could trigger a wave of profit-taking.

Action to take: The CBOE is benefiting from growing interest and trading volumes in options, lifting shares to a 61% gain in 2013. But with high margins, barriers to entrance and a strong financial profile this is also a company to own for the long haul. With a forward P/E (price-to-earnings) ratio of 24, in line with its peers but a premium to its higher-growth 10-year average, shares look a bit extended in the short run, making any weakness a chance to buy.

Michael Vodicka does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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