Options fear gauge retreats as U.S. stocks surge

CHICAGO (Reuters) - Wall Street's favorite measure of investor fear, the Chicago Board Options Exchange Volatility Index retreated on Monday after U.S. stocks rallied on news of a government plan to rescue Citigroup.

The widely-followed VIX dropped 10.97 percent to 64.70. It is down 20 percent over the past two trading sessions after spiking to a record close of 80.86 last Thursday.

The index tracks the projected stock market volatility for near-term Standard & Poor's 500 index option prices.

The drop in risk perceptions came as the S&P 500 benchmark gained 13.2 percent in its best two-day rally since the days following the October 1987 stock market crash.

The S&P benchmark jumped 6.47 percent to finish at 851.81.

"The demand for protection has basically subsided to some extent as investors feel a little more confident about the financial sector," said Herb Kurlan, chief executive of Vtrader Pro, a proprietary online trading firm in San Francisco.

The battered financial sector got a lift as investors applauded the decision by the U.S. government to inject $20 billion of new capital into Citigroup in an effort to prevent a bank collapse which could have endangered the global financial system.

U.S. President George W. Bush called the bailout necessary "to safeguard our financial system," and said the government would, "if need be," make similar decisions in the future.

Citigroup stock soared 57.82 percent to $5.95 after plunging to their lowest level in about 15 years on Friday amid uncertainty over the bank's future.

"The two-day decline in the VIX is due in large part to a rebound in the financials," said Frederic Ruffy, options strategist at New York-based Web information site WhatsTrading.com. "Citi is a big reason, with shares up more than 57 percent on Monday."

"Now, however, these stocks are well off their lows and the fact that the selling across the financial sector has subsided for now is one reason risk perceptions and the VIX are falling," he said.

Adding to the optimism, President-elect Barack Obama named his team of economic advisors.

"People are feeling a little bit better because President-elect Obama has made selections regarding his economic team and has started to implement strategies that dovetail what President Bush is doing," Kurlan said.

But volatility is still relatively high.

"The VIX reacted as you would expect it to on a stock market rally of this magnitude," said Joe Kinahan, chief derivatives strategist at online brokerage thinkorswim Group in Chicago.

"So what investors are looking for is an upside follow through or at least not an aggressive sell-off, as that is what it will take for volatility to stay at these levels or go lower."

(Reporting by Doris Frankel; Editing by Diane Craft)