Shares of Cboe Global Markets (NYSEMKT:CBOE) dropped by as much as 11% as of 10:30 a.m. EST, though they have since rebounded to trade down only about 7% as of 11:30 a.m. EST -- in response to the company's fourth-quarter earnings.
Cboe reported adjusted combined earnings per share of $0.87 in the fourth quarter, up about 12% from the year-ago period, but below Wall Street's consensus estimate of $0.88 per share. The adjusted combined EPS figure is calculated with certain adjustments primarily related to Cboe's February 2017 acquisition of Bats Global Markets so that earnings metrics are more comparable to prior periods.
Cboe Global Markets makes its money primarily from transaction-related fees earned when buyers and sellers of derivatives, including options and futures, transact on its exchanges. More trading volume means more revenue, and ultimately more profit for Cboe.
For now, investors are focused on volatility-related futures and options trades. That's because earlier this week, exchange-traded products (ETPs) that short the volatility index (VIX) blew up in a spectacular fashion when volatility readings soared on Monday. The VIX is commonly referred to as the "fear gauge," since it measures implied volatility based on how much or how little traders are willing to pay for options to hedge their investments.
This is complicated, but the short explanation is that a lot of money was being wagered on volatility staying permanently low or declining over time. That's a good thing if, like Cboe Global Markets, you make your money by running exchanges to facilitate trades to bet on the VIX.
So long as the VIX stayed low or declined, people who bet against volatility stood to make a lot of money. At its peak, the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ:XIV), which uses a short VIX strategy, generated compounded annual returns of 43% for roughly seven years running. That trade worked well, until it didn't -- this particular ETN lost more than 90% of its value when volatility soared on Monday.
The real question Wall Street is struggling to answer is how much of Cboe's volatility-related volume, and therefore its revenue and profit, is related to a trading strategy that has lost a lot of its luster in recent days. VIX options and futures have been an important driver of Cboe Global Markets' growth, as volume in these products grew at an astonishing clip of 23% year over year in 2017.
The company pointed out in its earnings presentation that the short VIX ETPs generated only about 4.4% of VIX futures' average daily volume in the fourth quarter of 2017. But ETPs are just one way that people were shorting the VIX. It's likely that some of Cboe's VIX-related volume was derived from other traders who will reduce their usage of short volatility strategies in light of its recently poor performance.
How many traders will simply take their losses and go home and how many will keep trading the VIX is the $64,000 question facing Cboe Global Markets shareholders today. It's not an easy one to answer, and at least some shareholders seem to prefer parting ways with the stock over waiting to see how it all shakes out.