Fear gauge surges, suggesting more U.S. stock turmoil

CHICAGO (Reuters) - The Chicago Board Options Exchange Volatility Index surged on Tuesday in a sign that more dramatic stock swings are expected in the near term as investors scrambled for protection on worries about the health of the banking sector.

The so-called VIX, Wall Street's favorite barometer of investor fear, jumped 10.54 points to 56.65, its highest close since mid-December. Underscoring the widespread selling in U.S. stocks, the fear index shot up 22.86 percent, its largest daily percentage gain since December 1 when it rose 23.96 percent, according to CBOE data.

"The VIX is representing the fear that we are seeing in all the financials, particularly the banks," said Joe Kinahan,

chief derivatives strategist at online brokerage thinkorswim Group in Chicago.

"Investors are willing to pay higher prices for options across the board to insure their portfolios."

The VIX, which tracks near-term projected stock market volatility priced into Standard & Poor's 500 index options, typically moves higher when stocks decline as investors bid up index options to manage their market risk.

The worries about the ongoing problems in the banking industry heightened risk perceptions and pushed the S&P 500 index down 5.28 percent to 805.22.

"This elevation in the VIX takes into account that we are again seeing more than 5 percent plus or minus moves in the S&P 500," said Chris McKhann, analyst at Web site optionmonster.com.

The latest concerns were sparked on Monday by Royal Bank of Scotland, which unveiled that it expects to take the biggest loss in British corporate history, when U.S. markets were closed for the Martin Luther King holiday.

U.S. stocks ushered in the Barack Obama presidency with a record Inauguration Day drop on Tuesday on fresh signs the global bank crisis was far from over.

State Street Corp led the declines after the world's largest money manager for institutions posted a $6.3 billion unrealized loss in its investment portfolio and lowered its outlook.

"With the financials getting slaughtered, people are getting concerned about another leg down in the market and are looking to hedge their portfolios with S&P 500 puts," said Scott Fullman, director of derivative investment strategy at broker-dealer WJB Capital Group in New York.

Although volatility is still high, traders are now looking for the VIX to settle down modestly over the next month.

Tuesday marks the last trading for January VIX options and futures. The expiring January VIX futures closed at 57.90.

The closest futures contract on the VIX suggests the fear gauge could be at 54.66 by February and at 51.08 by March.

(Reporting by Doris Frankel; Editing by Jan Paschal)