Futures Exchanges and Market Volatility

As the markets continue to ride the roller coaster, investors have choices to make in the equity markets. As I wrote last evening, there is money to be made in all market environments, this one is no exception. Some people have pulled out of the market which causes prices to sour more potentially creating increased opportunity. Some will re-enter the market with uneven timing. Many institutional investors employ derivative strategies, futures and options and there are ways to profit from their moves too.

When trading equity derivatives, stock options may be used or futures and options on futures contracts can be traded on the broad equity indexes. Stock options trade on various securities exchanges, whereas futures contracts trade on their own exchanges, and even have their own regulatory authority and rules.

The Chicago-based CME Group Inc. (CME) is a constituent in the Clear Global Exchanges, Brokers, and Asset Managers Index licensed for the ETF (EXB). The firm, which operates the Chicago Mercantile Exchange and Chicago Board of Trade futures exchange, offers diverse trading exchanges of futures contracts for a variety of U.S. commodities, currencies, fixed income securities and equity indexes.

Ignoring the market fluctuations in July/August for a moment, let’s look at the first half of 2007. CME benefits from volume, and as volume has grown this year CME’s year-over-year Net Income has grown 29.52%. Its one-year Return on Equity [ROE] of 30.29% doubles the industry average of 15.10%, and its Net Profit Margin of 38.26% is well above the industry 8.20% margin.

Why has futures trading grown so much? To better understand this we may look at the historical development of CME.

The history of modern futures trading began in Chicago in the early 1800s. Since Chicago is located at the base of the Great Lakes and close to the farmlands and cattle country of the U.S. Midwest, it was a natural center for transportation, distribution and trading of agricultural produce. As gluts and shortages of agricultural products would occur in the region chaotic fluctuations in prices would also occur. To address this problem, a trading market developed that enabled farmers, processors and sellers of agriculture products to trade in cash forward contracts related to these commodities. Such contracts would insulate them from the risk of adverse price changes by allowing them to hedge against such fluctuations and consequently stabilize prices to consumers.

In 1898, the roots of CME were first established to help dairy, and egg farmers stabilize their prices with the formation of the Chicago Butter and Egg Board which eventually became known as the Chicago Mercantile Exchange in 1919. In 1972, the exchange created the first financial futures contracts by introducing futures on seven foreign currencies. The introduction of stock index futures contracts shortly followed.

In the late 1980s, the Chicago Mercantile Exchange developed, and received regulatory approval for its Globex Electronic Trading System. This was no small task in the face of a deeply embedded regulatory tradition that preached open outcry as the only fair auction method to trade futures contracts. This past July, CME was formed when the Chicago Mercantile Exchange significantly expanded its product base with the acquisition of the Chicago Board of Trade [CBOT] making it the operator of the largest futures exchanges in the world with respect to the number of outstanding contracts.

Today, futures trading has evolved well beyond price protection for farmers living in Midwest America. Futures and options on futures contracts are offered in a multitude of product areas, including interest rates, equity indexes, foreign exchange, agricultural commodities, and energy, as well as alternative investment products, such as weather, real estate, and economic derivatives. Futures trading has become heavily inter-related to a wide variety of markets and applied in a multitude of investment strategies globally.

The beneficiaries of this has not only been the futures brokers and exchanges, but also investors, by providing other ways to better manage risk and weather the volatility storms as they pass through the various trading markets.

At this moment of volatility and big market swings, and, with the proliferation of hedge funds, futures trading has escalated. Trading volumes of futures contracts have reached historical heights as more investors seek to hedge the risk on their portfolios and make bets of the direction of certain securities. High volatility in the markets has most likely been financially favorable for CME and other exchanges.

The question for EXB is: have the brokers and asset managers been oversold while this volume spike in exchanges has not been realized in the stock prices of the exchanges? If that is so, a bounce back in this ETF could prove significant.

Disclosure: Mr. Corn is CEO of Clear Indexes LLC which publishes the Clear Global Exchanges, Brokers and Asset Managers Index that is licensed by the ETF (EXB). Mr. Corn owns shares of the ETF (EXB), and does not directly own shares in (CME).