An Investment In Future Speculation

| About: CBOE Holdings (CBOE)

Summary

CBOE is a strong long-term candidate based on a wide-economic moat, steady cash flows, and a high return on capital.

As more investors learn options and the world's money remains in derivatives, it's a worthwhile investment to gain exposure to a strong player in the derivatives market.

Expect above-market return to continue as CBOE innovates into the future of derivatives.

Many people think or would like you to believe that investing has fundamentally changed over the years. I will let you in on a little secret, it has not. The deeply rooted fundamentals of investing versus gambling have not changed.

In April of 1973, a group gathered in the Chicago Board of Trade smoking lounge and offered the first form of standardized stock option contracts. A total of 911 contracts changed hands and the option industry (as well as the Chicago Board Options Exchange (NASDAQ:CBOE)) was born.

Now, if you were able to place yourself in this room in 1973, imagine if there was a man who collected a fee from each contract traded and every contract afterwards into perpetuity. If we use the average revenue per contract from the latest Chicago Board Option Exchange 10-Q the result is $0.085 per contract or [(911*.085) = $77.44]. Adjusted for inflation this is really only about $14. As an investor, this would be the most lucrative position to be in; but many people would not be interested in this mere $14 and would instead speculate the volatility of the market and potentially "get rich quick." Since CBOE's existence their returns have outpaced the S&P 500, and in the last 5 years the returns have been more than double that of the S&P 500.

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We've all heard the trite saying, "The house always wins," which is why I am pitching a "buy" on the brokerage houses of which trading in the derivatives market takes place. An interesting financial visual which shows how much money is in derivatives is here. As you will see, most of the world's money is in derivatives! Now, a derivative is just a fancy way of saying a contract that "derives" its value from an underlying security (stock, bond, etc.). A quick back peddle about my assumption is not that options are gambling, in fact, I think options can be useful in risk management. However, I do believe their is a growing number of options traders who take excessive risk and over-speculate which is essentially gambling.

CBOE is the largest options exchange in the US based on total contract volume. In 2015, their market share was 27.1%. To achieve these competitive strengths innovation was crucial in enhancing product offerings. In fact, CBOE has developed leading products in the options and volatility space including the VIX Index (1993), VIX futures (2004), and options (2006). In 2015, the introduction of VIX Weeklys provides investors new opportunities and tools to trade volatility. While these product volumes will be sensitive to market volatility, to me this makes this stock even more attractive - when volatility is spiking - higher volumes are traded in the volatility space and shareholders benefit. With the upcoming Fed meeting in July, the presidential election, and the equity rally since the 08-09 recession I think it's reasonable to expect volatility this year.

This stock has a wide competitive moat based on various strategic partnerships. With the exclusive right to offer option contracts on the S&P 500 Index and the S&P 100 Index through 2033 and 2032 respectively. Also the company has various licensing agreements with FTSE Russell, a non-exclusive right to offer contracts on the NASDAQ 100 through the VXN (a volatility index on this exchange).

The most notable is the S&P 500 Index which contributes substantially to the volumes and transaction fees of CBOE. One of the fastest growing products is the SPX Weeklys which had changed from a percentage of total contracts traded from 2% in 2010 to 36% in 2015. Per the latest 10-Q:

We believe that traders are using this product to fine tune the timing of hedging strategies and maximize the risk premium in strategies that involve the sale of options, such as covered call writing.

Other metrics make this company highly lucrative including average return on equity of roughly 70%, healthy trends in cash flow and capital spending, and no debt.

Interestingly, short-interest has risen from 2% to 6% in the last few months and this is something to keep an eye on. My estimated intrinsic value for CBOE is $75 per share, when will the price meet this intrinsic value? That I do not know, which is why I am pitching the stock not the option. Cheers.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CBOE over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.