CME Group Stock, Up 20% YTD, a Play on Increased Volatility

YCharts

While stock market investors celebrate the ongoing stock market rally and the recent new highs recorded by the Dow Jones Industrial Average, shareholders of CME Group (CME) are welcoming something slightly different: a return of market volatility.

The reason? CME Group runs the world’s largest futures exchange, and the long-term trend has been a shift away from trading in its core agricultural and other commodity related futures and options products to financial derivatives, ranging from currency options to futures contracts tied to key stock market indexes. Investors use these to take a view on the direction of the market: a hedge fund manager might use CME-traded products to rapidly and inexpensively take a view on a specific stock or market segment, while other institutions use S&P 500 futures and other contracts to execute their asset allocation decisions or respond to shifts in the market.

In all cases, it is volatility that helps drive trading volumes, and thus the exchange’s revenues and profits. Volatility creates uncertainty, and thus an increased interest in using futures and options to hedge positions or put shorter-term, opportunistic trades in place. And volatility has been on the rise: in the final two weeks of 2012, for instance, the VIX rose 25%. And while it didn’t stay at its highs, any sign of uncertainty amidst the rally was met with an upsurge in volatility: average daily trading in futures on the VIX itself, formally known as the CBOE Volatility Index, set an all-time record in February.

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CME Chart

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CME Chart

Uncertainty about what may happen next in the bond markets also has been good news for CME Group, as seen in a stock chart. CME's valuation, or its PE ratio, quickly rose. The early signals that the Federal Reserve is at least beginning to think about how it would set about reversing its policy of ultra-low interest rates sparked interest in the exchange’s bond futures. Together, that and the stock market volatility sent trading volume at the CME to an 18-month high in February, up 7% over year-earlier levels. Meanwhile, trading volumes at the IntercontinentalExchange Inc. (ICE), emerging as a key rival to the CME Group thanks to the former’s pending acquisition of NYSE Euronext (NYX), slid 10% as interest in trading natural-gas futures and options declined.

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CME Forward PE Ratio Chart

Futures trading is one market in which incumbents have an even more pronounced advantage. When a given exchange has become the key place for liquidity in a given contract, it can be hard for a rival to woo investors away. So the relatively narrow valuation spread between CME Group and ICE may not reflect the real nature of their current market importance. Yes, analysts are predicting hefty gains in earnings for ICE, especially as it acquires the NYSE and Euronext businesses, which will greatly increase its market share of financial futures trading activity. But any merger involves uncertainty and execution risk. Meanwhile, CME is the established market leader.

The two exchanges likely will soon go head to head, with both planning to introduce futures contracts tied to credit default swap indexes. That’s likely to be a big market, as trading volumes in the real over-the-counter products have slumped since the financial crisis, while investors are eager to find a way to take positions on credit default swaps in a less costly and more transparent way than those customized derivatives made it possible to do. ICE last year signed a pact with Markit to license the latter’s CDS index sets; it remains to be seen what indices CME will use as the basis for its own futures contracts.

There is a chance that ICE could grab the lion’s share of that market out of the gate, and many investors have opted to take positions in both exchange groups for that reason. That gives them a foot in both camps: a way to play the riskier ICE growth scenario without abandoning the market behemoth. In either case, however, It seems clear that finding a way to profit from market volatility may be a wise plan, and doing so indirectly by investing in the futures exchanges that benefit from volatility is a far less risky strategy than trying to play in VIX futures contracts themselves.

Suzanne McGee, a contributing editor at YCharts, spent nearly 14 years as a reporter at the Wall Street Journal, in Toronto, New York and London. She is also a columnist for The Fiscal Times, and author of "Chasing Goldman Sachs", named one of the best non-fiction books of 2010 by the Washington Post. She can be reached at editor@ycharts.com.


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