Investing with the ‘House’ In Today’s Frenetic Market

October 30, 2020 Jimmy Butts

Chances are you’ll continue to hear a lot about the VIX, or Volatility Index, in the coming weeks. The VIX is a popular measure of the stock market’s expectations of volatility over the next 30 days, based on S&P 500 index options.

As expected, the VIX has spiked higher with the recent market volatility (read declines) this week. You can’t trade the VIX directly but you can purchase options on the VIX as well as utilize exchange-traded funds based on the index.

One thing you can trade directly is the company that created the VIX in 2004. The VIX, by itself, is not a reason to invest in this company, of course. But contributor Jimmy Butts has come up with some others.

— Bob Bogda, Editor

P.S. Like what you see? Don’t like what you see? Let me know.

 

 

If you’ve been to a casino, then you’ve likely heard — or, sadly, even experienced — the phrase, “The house always wins,” which means that regardless of your success the house, or casino owners, will always net a profit.

Still, folks continue to gamble their money away, even though they know the odds are stacked against them. Perhaps it’s the thrill of the game, or an overly optimistic view that they might strike it rich with the next hand or next roll of the die.

Whatever the outcome, the house will get its cut.

Many people who enjoy the thrill of a casino also enjoy the thrill of the stock market. We’ve seen these folks come to the market in droves recently, as the coronavirus pandemic halted games to bet on and as casinos were shuttered. And don’t try to tell me that none of those $1,200 stimulus checks didn’t find their way to an E*Trade account or two.

To give you an idea of just how many new investors have flooded the market, we need look no further than brokerage firms’ daily trading activity. This metric, which goes by the acronym “DARTs”, or daily average revenue trades, has exploded in recent months.

For instance, TD Ameritrade’s DARTs for the first three quarters of 2019 averaged just above 800,000. In June its DARTs soared to more than 3.8 million. The brokerage firm also added a record 661,000 new retail accounts in the second quarter of this year. This was after the brokerage added 608,000 in the first quarter.

Looking at popular mobile trading app Robinhood, the statistics tell a similar story. The total number of equity positions held by Robinhood users jumped from around 5 million in February to more than 14 million by mid-summer.

There’s little question that we’re in the midst of an epic trading boom fueled by increased retail participation in the stock market.

Some skeptics view the surge in new traders as an ominous sign… We’ve seen headlines comparing this market to that of the dot-com bubble in the early 2000s when folks were piling into internet stocks. Virtually any internet stock.

Here’s the good news: Instead of chasing the next hot stock, or trying to keep up with all these Robinhood traders, or worrying about whether your holdings are going to crash tomorrow, you can put your money on “the house.”

Right now, the house is happy to see all these new traders. It’s a direct beneficiary of the boom in retail trading, and it doesn’t matter whether these newly minted investors win or lose, because the house will still take its cut. And despite the surge in new traders, the house right now is trading for cheap…

 

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Investing in The Stock Market ‘House’

Cboe Global Markets (BATS: Cboe) provides a marketplace for equities, options, futures, and foreign exchange instruments.

Despite the “no-commission” trades that many brokerage firms now offer retail customers, these brokerages still must pay a fee to the exchange on which it participates.

When you place a trade to buy 100 shares of a stock, your broker routes that order to a marketplace that has a seller for that stock. If that marketplace is owned by Cboe — which owns four stock exchanges — then your broker will pay a transaction fee to that exchange for providing the liquidity and marketplace for that transaction to take place.

Think of it like the credit card company, Visa (NYSE: V). Every time you swipe your visa card, the merchant must pay a small transaction fee to Visa for facilitating the purchase. The Cboe acts in a similar fashion.

And these small transaction fees quickly add up to big revenues for Cboe…

In 2019, Cboe generated nearly $2.5 billion by providing a marketplace for equity, options, and futures trades. And as new investors have flooded the market — and transactions have increased — so too has Cboe’s revenue.

In the first quarter of 2020, Cboe pulled in $921.5 million in revenue, a 52.9% increase over the same quarter a year earlier. Things didn’t slow down much in the second quarter, either… sales jumped 40% in April-June over the year-earlier period.

The beauty of providing a marketplace for these transactions to take place is that it’s extremely profitable.

In 2019, on its $2.5 billion in sales, the company generated cash operating profits of $632.8 million. In other words, for every $1 in sales that comes through the door, just over a quarter trickles down to cash flow.

That’s a wonderful business model. One that most folks would pay a slight premium for. But right now, Cboe is trading at a massive discount.

Over the last five years, investors have been willing to pay, on average, about 32 times earnings for each share of Cboe. Today, shares change hands for just 19.3 times earnings — a 40% discount to its five-year historical average.

You’ll see a similar story play out when looking at every other valuation metric.

As you can see, this cash-generating machine is trading at a historically cheap discount, which is great for long-term investors. We can pick up shares of the market’s “house” and make money regardless of whether all these new traders win or lose.

Action to Take: Buy shares of Cboe Global Markets (BATS: Cboe) up to $95 a share. Look to sell half your position once you’re up 100%.

 

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