This has been another year of extreme market volatility. In May, after rallying to a new multi-year high in the first four months of the year, the S&P 500 saw a sharp 9% pullback before retracing all those losses in June and July. Crude oil has fared much the same, topping off above $106 this spring before cratering to $78 and then rebounding sharply to the mid $90s. This volatility has also been on display in agriculture, where corn, beans and wheat all rallied to all-time highs this July as a blistering drought swept across the Midwest.
But unless you're a professional day trader, spending 12 to 16 hours a day glued to a wall of flat screens, it can be hard to profit from higher levels of volatility. And in spite of an occasional spike here and there, using the Chicago Board Options Exchange's Market Volatility Index (VIX) to bet on volatility has been a losing bet this year.
That's why my favorite way to cash in on the trend is by investing in over-the-counter derivative exchanges, since they directly benefit from high levels of volatility and trading volumes. A derivative is a financial contract between two parties, with a value derived from an underlying asset -- commodities, currencies, bonds, etc.-- This value is based on future price movements. Because of this characteristic, they can serve as a hedge against risk for one party, while offering high returns for the other party.
This is the exact trend that lifted the CME Group Inc. (NYSE: CME) to a massive 800% gain from its IPO in the fall of 2003 to its high-water mark in the fall of 2008. Take a look at the huge, market-beating gains below.
But if you missed out on those big gains, then don't worry, because history is repeating itself. There is another publicly-traded, domestic derivatives exchange that is in the early stages of a long-term growth trend.
What makes Intercontinental Exchange so unique is that unlike other exchanges, it is exclusively electronic, enabling it to avoid higher overhead costs from maintaining an actual trading floor. But beyond its status as an electronic derivatives exchange, it has been strategically positioning itself to take advantage of growing trading volumes in the energy and agriculture markets.
The company is a pioneer in energy trading, launching one of the first electronic West Texas Intermediate (WTI) Crude contracts in 2006, and enabling speculators and hedgers alike to bypass expensive floor brokers and gain access to sophisticated financial products with extra liquidity and transparency.
Since then, the company's presence in the energy markets has done nothing but grow. If fact, July was the first month that the Intercontinental Exchange's Brent Crude contract saw higher daily trading volumes than the CME Group's WTI contract, signaling a fundamental shift in trading preferences.
Looking forward, Intercontinental Exchange has big plans to grow its energy business. It's set to launch 28 new energy contracts in late August, including natural gas liquids, North American power, liquefied natural gas, and global oil and refined petroleum products.
But it's not just all about energy. The Intercontinental Exchange is also pursuing growth in lucrative agriculture markets, reporting record trading volumes in July for its new grain contracts positioned to compete against the CME Group, and other domestic and international grain exchanges.
The company also continues to execute its strategy for international growth, opening clearing services in late July for sovereign credit default swaps (CDS). And even in Europe, where many companies continue to struggle, the Intercontinental Exchange recorded record daily volume of 26,000 contracts in late July in its heating oil futures contract, another example of how the company is uniquely positioned to benefit from market volatility and uncertainty.
There has also been a wave of consolidation sweeping through derivative exchanges in the past few years, with the CME Group buying the Chicago Board of Trade and New York Mercantile Exchange. Internationally, in 2011, the Germany-based Deutsche Boerse bid $9.53 billion for NYSE Euronext Inc. (NYSE: NYX) before the deal collapsed. Both are examples of the benefits of consolidation in the growing industry, which means InterContinental's $9 billion valuation and high-income energy contracts make it an attractive takeover target.
Risks to Consider: The growing regulatory environment in financial services related to trading volumes and compliancy expenses poses a threat to Intercontinental Exchange. So far, the company has used the growing regulatory environment to its advantage, releasing new clearing services for over-the-counter products related to the Dodd-Frank financial regulation legislation. But moving forward, increased energy-trading regulations and margin requirements would weigh on earnings.
Action to Take --> Intercontinental Exchange is one of the fastest growing equity derivatives exchanges in the world, with new product offerings and general market volatility driving trading volumes. But in spite of record sales and earnings, shares still trade at about 30% below the all-time high of $178 in 2007. Returning to historical valuation of the last 10 years of 21 times forward earnings implies 24% upside from current levels.