Trading in Cboe Global Markets, Inc.'s (NASDAQ:CBOE) proprietary VIX (Volatility Index) instruments could be characterized as, well, volatile over the past three months. Last quarter, I noted that VIX futures volumes were "spirited." During the global exchange operator's second quarter of 2018, however, VIX-related activity reversed course.
We'll delve into the factors behind weaker futures volume after walking through the raw numbers from Cboe's otherwise impressive quarterly report.
Cboe Global Markets: The raw numbers
|Metric||Q2 2018||Q2 2017||Year-Over-Year Growth|
|Revenue||$283.5 million||$266.9 million||6.2%|
|Net income||$82.4 million||$67.3 million||22.4%|
|Diluted earnings per share||$0.73||$0.60||21.7%|
What happened with Cboe Global Markets this quarter?
After several quarters of double-digit increases, net revenue from futures trading declined by 13% to $31.4 million. The change in direction was paced by a 16% drop in VIX futures average daily volume. Management attributed the softer volume to diminished interest in income-generating strategies among VIX traders.
Specifically, when the market for VIX futures contracts is in contango (in other words, futures contract prices are above their expected future spot prices), traders who are short volatility can collect a premium by rolling an expiring futures contract into another. Management noted that because of a recently indeterminate VIX term structure (i.e., an ambiguity on whether the market would remain in contango or flip to its opposite, in a process known as "backwardation"), this "roll-down" premium trade netted only one-third as much profit as it produced during 2017.
Now, as an investor, why should you care about this admittedly technical explanation from Cboe's executives on a key factor behind overall results? VIX instruments, along with Cboe's Standard & Poor's 500 Index (SPX) options, have provided much of the company's organic growth over the past two years. Healthy VIX futures volume is essential to the company's continued expansion.
As I've discussed previously in recent quarters, the VIX has experienced quite a year so far, from a spike in February from a brief market slide, to now-dissipating investor concerns that the index's closing auctions might be subject to trader manipulation (see the link back in the first paragraph).
An offset to VIX weakness
A pullback in VIX activity didn't sink Cboe's quarter, however. Options net revenue increased year over year by 8% to $134 million. The advance resulted from a single-percent-increase in volume, coupled with a 7% improvement in revenue per contract. Within this segment, SPX options trading increased by 18% against the prior-year quarter. Cboe management stated that market conditions favored the use of SPX options over VIX futures during the quarter, since, given a choppy trading environment, options provided a more cost-effective means to hedge risk for institutional investors.
CEO Edward Tilly observed that the company's two leading risk-management offerings, VIX futures and SPX options, proved to be complementary platforms over the last three months. Indeed, during the second quarter, Cboe still managed a revenue advance as traders and investment managers favored SPX options over VIX instruments.
Other notable highlights
- Outside of futures and options, Cboe's remaining segments each posted expansion against the prior year.
- U.S. equities net revenue improved by 4% to $77.6 million on higher fees for market data and exchange services.
- European equities net revenue jumped 26% to $23.4 million. After adjusting for 14 percentage points of favorable foreign currency translation, the segment still notched a healthy double-digit top-line increase, because of higher volumes and growth in net transaction fees.
- Global forex, the company's smallest segment, posted a 33% jump in net revenue to $14.5 million, also on stronger volume and higher net transaction fees.
- Cboe bumped up its quarterly dividend by 15% to $0.31. At the current share price, this equates to an annual yield of 1.3%.
- Adjusted operating margin (which removes the amortization of intangible assets related to Cboe's 2017 acquisition of Bats Global Marketplace) rose 60 basis points over the second quarter of 2017, to 62.6%.
What management had to say
In his prepared remarks on the company's Aug. 3 earnings conference call, Tilly provided investors with a glimpse of current trends on both VIX futures and SPX options following the end of the second quarter:
Recently though, we have seen a return to the stable upward sloping pattern that is more conducive to short-volatility strategies. In July, the VIX futures curve was in contango every day and the average roll-down premium recovered to just under 2017 levels.
With stock prices largely recovering from their February lows and the ever-present threat of a global trade war, we are seeing growing demand from market hedges. Not only has SPX options volume remained solid, but in May and June, we began to see more large trades in VIX options as the VIX Index trended below 15 for the first time since February, and [averaged] just over 13 in July.
In essence, Tilly is pointing out that the low-volatility conditions that have previously benefited both Cboe's futures and options platforms appear to be returning -- at least for now.
In regard to an earnings outlook, Cboe doesn't provide investors with revenue, net income, or earnings-per-share guidance. However, management does project a full-year expense tally, which it updates each quarter. For the full 2018 year, Cboe reaffirmed its adjusted expense target of $420 million to $428 million, which excludes the amortization of intangibles mentioned above. Costs are under control; any pickup in revenue in the second half of the year should positively affect the bottom line.