CBOE Holdings

2/25/12

When I look at the financial stocks, I wanted to stay away from all the banks, as they will continue to be negatively affected by problems in Europe, Dodd-Frank laws and Basel III.  However, that being said, there are still some very strong financial plays such as Mastercard, Visa and lately, Chicago Mercantile Exchange.  I think all three of those stocks have already run up too much to invest in, so I looked for a new favorite of mine to have a big breakout to the upside, CBOE Holdings (CBOE).  The CBOE offers a marketplace for options, futures, ETFs and equities.  In simple terms, every option contract that is traded runs through the CBOE.  I think the stock is currently well undervalued with only 2 buys, 13 holds and 2 underperforms.  With the closing on Friday at $27.65, analysts seem to be way off the mark with their average price target being $26.63 (a price the stock gapped above which I’ll talk more about later). 

            CBOE recently reported a record Q4 and FY11 as they saw record trading levels in the SPX and volatility options and futures with 4.8M contracts trading each each day, for an increase of 10% over 2010 (impressive numbers considering the MF Global debacle cut down on trading).  The Q4 saw a record EPS of $0.37 on revenues of $120.2M.  VIX options volume in 2011 rose a record 57%.  Management is very excited about its’ future prospects, as well as myself, as they plan to introduce many new contracts in 2012.  They are rolling out new volatility benchmarks and tradable products including sector ETF and single stock VIX products.  On January 9^th, CBOE introduced new Emerging Markets ETF volatility indexes. 

            While option trading on the floor may be diminishing, electronic trading isn’t.  Every hedge fund in the world is trading options to protect their downside risk on their long positions.  Additionally, Jon Najarian, Options trader and CEO of OptionsMonster recently noted that while equity volumes are not nearly as high as they used to be, options volumes are skyrocketing through the roof, which is all bullish news for this stock. 

            Looking at the financial situation, the CBOE trades at just 15x forward earnings with a PEG ratio of only 1.65.  The company is debt free with almost $135M in cash on hand, paying out a $0.48 dividend (1.70%).  With a payout ratio of below 30% of net income, they have plenty of room to continue to raise the dividend.  CBOE operating margins are an astronomical 47.55% and should continue to expand with high margin products being introduced into the marketplace. 

            From a technical perspective, this stock seems to be on the verge of a major breakout to the upside.  Looking at a daily contract, CBOE has built a perfect inverted head-and-shoulders over the last 52 weeks.  Recently, after reporting their record earnings, CBOE gapped above the neckline, indicating a breakout.  After going three days without filling the gap, the stock should continue to rally away from the gap.  What’s even more interesting, and bullish for that matter, is CBOE gapped above the 61.8% Fibonacci retracement of $26.63 (which as mentioned previously, just so happens to be the incorrect average price target for the stock).  On Thursday, the stock build a bullish engulfing line that engulfed the previous six days of price action, indicating a move down is very unlikely in the near term.  CBOE is currently trading well above the 50 and 200 day moving averages, $26.13 and $25.28, respectively.  With an RSI (Relative Strength Index) of 62, CBOE is not overbought.             

            I think there’s tremendous upside for this stock as I see trading volumes greatly increasing.  With continuous problems in Europe and with a new Presidential election coming up, volatility trading should skyrocket.  I think the new products that CBOE is introducing this year will be received with great fanfare.  If CBOE was able to hit record earnings and revenues on what was slower than normal volumes, it’s hard to imagine the stock going much lower as volume picks up.  Buying CBOE at Monday’s open is a good entry point for this stock ($27.65).  I look at this as being a very long-term play (about a year) and while it could move around a little big, up or down, I see the stock hitting $35 for a 27% gain.  Use the 50% Fibonacci as your downside stop loss at $25.66 for about a 10% loss, but I don’t think you’ll get there. 

             Full disclosure:  I currently am long CBOE from $27.26 and plan to at $28.50. 

Jeff Lewison