Dow Jones Newswires | The marquee contract at the Chicago Board
Options Exchange is being overtaken by a generic copycat in a move that
will likely color valuations ahead of a planned initial public offering
in June.

The CBOE franchise is driven in part by exclusive index contracts for
valuable products such as the Standard & Poor’s 500 index option,
which accounted for more than a fifth of group revenue last year. 
However, the rise of exchange-traded funds has seen volume in similar
options on the S&P 500 SPDR Trust–a non-exclusive contract
available on all U.S. options exchanges–overtake the S&P 500
contract, better known as the SPX.

“There’s no doubt the value [of the SPX] isn’t what it once was,” said Paul Zubulake, senior analyst at Aite Group, a consultancy.

The CBOE claimed 30 percent of the U.S. options market last year thanks in part to the exclusive index deals, and potential investors have long eyed their contribution during the company’s protracted four-year march toward a stock market listing.

The exchange revealed for the first time in a regulatory filing last month that the SPX generated $92.5 million of its total $426.1 million in operating revenue last year.

The contract remained the most actively traded at the CBOE despite a 13 percent drop in average daily volume from the previous year to 614,562 contracts.

CBOE doesn’t break out the revenue contribution of the SPDR Trust contract, or SPY option, whose average volume across all exchanges rose 8.6 percent to 1,379,753 contracts last year, according to figures from the Options Clearing Corp.

However, the CBOE’s leading position in SPY options trade has shrunk, falling from 34.7 percent in 2007 to 24.9 percent last year, just ahead of the International Securities Exchange’s 23 percent.

The U.S. options market is among the most fiercely competitive derivatives sectors, with eight exchanges vying for business.

The earnings potential of the SPX is challenged by its similarity to the SPDR for many users.

Despite technical differences in contract specifications, “they’re virtually the same options,” said George Ruhana, chief executive of Chicago-based brokerage OptionsHouse LLC.

SPX options haven’t gained the same ground partly because they’re more expensive, since the index itself trades at a level that’s ten times as high as the SPY. That makes SPX options largely inaccessible to retail investors.

At the same time, however, SPX options remain popular among institutional investors, who often use options to hedge large portfolios of stock. Because SPX options have a higher notional value than SPY options, investors can buy fewer contracts and thereby reduce transaction costs.

“Investors are charged per contract and these costs are definitely a large factor” for investors who buy and sell SPX options, said Pat Kernan, a trader of SPX options and owner of Cardinal Capital Management.

Institutional investors’ preference for the SPX options, due to their larger notional size, have also played into the market’s relatively flat growth. Consolidation and deleveraging among banks and hedge funds over the last two years means less big traders using the product.

The biggest factor may be the fact that nearly all SPX trading takes place on the trading floor. The complex nature of many large SPX orders lend themselves to the Chicago pit, where a crowd of market makers help facilitate multi-part transactions.

With the CBOE aiming to launch an all-electronic exchange dubbed C2 later this year, some see the potential for the SPX market to migrate toward the screen and grow in the process.

“If it’s a very popular institutional product, which it is, with a very deep and liquid market, then I don’t see why it wouldn’t see significantly higher volume if it went electronic,” said Jeff Shaw, head trader at Timber Hill, the market-making division of Interactive Brokers Group Inc. (IBKR).

SPX trading activity could come under pressure as rival options exchanges seek to capture more business from institutional investors.

NYSE Euronext (NYX) plans to relaunch so-called “jumbo” ETF options, first introduced in the late 1990s, later this year pending approval from regulators.

Besides jumbo SPY contracts, which would settle for 10 times the size of standard SPY options, NYSE Euronext is planning similar-sized products around the Powershares (QQQQ), Diamonds Trust (DIA) and iShares Russell 2000 (IWM) ETFs.

Meanwhile the International Securities Exchange, the fourth-ranked U.S. options exchange by volume and a unit of Deutsche Boerse AG (DB1.XE), has been waging a years-long battle to break CBOE’s monopoly on SPX options.

It filed a lawsuit in 2006 seeking access to the market. Both sides have filed for summary judgment in the case and are awaiting a decision by the judge, with oral arguments set for mid-May.

-By Tennille Tracy and Jacob Bunge, Dow Jones