This Company Is Winning as the Retail Trading Frenzy Continues

Investors are spending record amounts to protect their portfolios (or speculate on further downside).

Last week, as the S&P 500 Index flirted with a 10% correction, Bloomberg noted that smaller retail traders – trading 10 contracts or less – were buying put options in record numbers. These allow the put buyer to offload their shares for a predetermined price, even if the stock is trading well below it – capping their downside.

The record put volume is just another chapter in the retail trading frenzy. Ever since the pandemic hit, trading volumes have surged and volatility has been cranked up to a consistently high level.

That's great news for today's company...

CBOE Global Markets (BATS: CBOE) runs an options exchange in the U.S. That used to be its sole revenue source – but after acquiring BATS Global Markets in 2017, the company expanded into U.S. equities, European and Asian equities, and foreign exchange.

The CBOE now accounts for 13% of the U.S. equity market volume, though options – where it accounts for about 30% of all volume – are still its bread and butter. In the most recent quarter, options accounted for over half of CBOE's total revenues.

As an exchange operator, CBOE has a simple – but extremely capital efficient – business model...

By matching a buyer to a seller on one of its exchanges, the CBOE receives a transaction fee from the broker. These types of fees make up the CBOE's "transactional revenue." And since volumes typically increase in times of elevated volatility, that means higher transactional revenue from trades.

This part of CBOE's business got a huge boost during the pandemic as people stuck at home resorted to "day trading" stocks. But the high volumes haven't declined yet...

Last week, CBOE released its trading-volume data for January 2022. It recorded its second-highest monthly total of options contracts traded ever – at 282.5 million. On January 21, the number of options contracts traded set a single-day record of 21 million.

In addition, 6.1 million futures contracts were traded on CBOE's exchanges, for an average of 303,000 contracts per day. That was the highest level for futures trading since the pandemic crash in March 2020, when volatility skyrocketed and the CBOE Volatility Index ("VIX") peaked around 80 – well above its pre-pandemic level of around 15.

CBOE also has another way to profit... It has a "monopoly" on fear in the markets – the VIX is CBOE's intellectual property.

The VIX has become the market's so-called "fear gauge." But it doesn't track fear, per se. It gives you the implied volatility of the S&P 500 over the next 30 days... basically, the expected range of index values.

Since CBOE created the VIX, it has a monopoly on VIX options. So if investors want to bet on higher (or lower) volatility through the VIX, they have to turn to CBOE.

As we mentioned above, this is a very capital-efficient business... meaning it doesn't require big capital expenditures to maintain and expand the business. Operating an exchange is a fantastic business with mile-wide margins. It doesn't cost CBOE much – if anything – to execute trades or give access to its exchanges.

One of the best ways to see this is through CBOE's free cash flow ("FCF"). Put simply, FCF is the cash left over after all expenses and capital expenditures ("capex"). Over the past five years, CBOE's FCF margin (FCF as a percentage of sales) has averaged about 25%. That's a fantastic percentage. But it has gotten even better in recent months...

Over the past 12 months, CBOE's FCF margin has come in at 45%. And with all this FCF, the company can return capital to shareholders.

In the fourth quarter, CBOE paid out $51.5 million in dividends. And it has more than $300 million remaining on its share-repurchase authorization, so the capital returns should only continue from here.

The recent quarter was another sign of strength for CBOE...

The trading exchange reported fourth-quarter earnings per share ("EPS") of $1.70 versus the $1.54 estimate. Revenue for the quarter was $390.5 million, beating Wall Street's expectation of $389.3 million. That represents 27% growth from the same quarter in 2020. And CBOE reported record revenue of nearly $1.5 billion in 2021, up 18% from 2020.

The strong revenue growth was driven by the surging trading volumes we discussed above. All of CBOE 's segments – options, North American equities, European and Asian equities, and foreign exchange – reported higher transaction and clearing fees in the quarter.

CBOE also grew its market share in European equities and global foreign exchange, while maintaining strong market share in North American equities and the options market.

The company reiterated its 2022 revenue growth forecast of 5% to 7%, above the Wall Street estimate of 4.9% growth.

Trading volumes have shown no signs of easing. And volatility is still elevated. That should serve as a tailwind for CBOE's shares.

Sometimes investing is simple.