Options fear gauge drops sharply as U.S. stocks rally

CHICAGO (Reuters) - Fear and volatility beat a hasty retreat on Tuesday. The Chicago Board Options Exchange Volatility Index .VIX, Wall Street's favorite barometer of investor fear, fell sharply as U.S. stocks rallied from 12-year lows.

The VIX lost 10.69 percent to 44.37, as the pressure of protective option premiums gave way and the underlying Standard & Poor's 500 .SPX benchmark shot up 6.37 percent to 719.60.

The steep decline in the VIX reflected a combination of selling premium and likely profit-taking in S&P 500 index options.

U.S. stocks posted their best day in four months after Citigroup (C.N) said it was profitable in the first two months of 2009 and a key lawmaker said he expected the reinstatement of the so-called "uptick" rule than hinders short-selling.

The rule slows the pace of short selling or bets that a stock will fall and could help calm volatile markets.

"We are seeing a reduction of fear with the good news from Citigroup today. So perhaps there is a light at the end of the tunnel," said Joe Kinahan, chief derivatives strategist at online brokerage thinkorswim Group in Chicago.

"Options traders do not feel as great a need to pay high prices for protection and in fact, many are selling their positions previously put on as protection," he added.

The VIX tracks projected stock market volatility embedded in near-term S&P 500 .SPX option prices and generally moves inversely to the S&P benchmark.

"Risk perceptions are slightly declining and the urgency to hedge long portfolio positions has diminished," said Scott Fullman, director of derivative investment strategy at New York-based broker-dealer WJB Capital Group.

The VIX, the 30-day risk forecast, broke below the 21-day and 50-day moving averages of 47.18 and 45.46, respectively, he said.

Although volatility caved in, the demand for protection from option contracts may still exist due to concerns over the financial system's stability and how long the economic downturn may last.

"Even though stocks are up significantly, it would be premature to make any assumption that the bear market is over," Fullman said.

"Investors have to be aware that so far this is a one-day rally off of extremely depressed prices with what remains an extremely gloomy macro economic outlook," said Andrew Wilkinson, senior market analyst at Connecticut-based Interactive Brokers Group.

Some option investors appear to believe that the decline in the VIX will be limited, he said.

With about a week to go before expiration, option traders have been selling March VIX put premiums in the expectation that the VIX will settle above an index value of 35, he said.

Other action is in the March VIX calls at the 65 strike, where 8,000 contracts traded, which appeared to be bought, he said. The June VIX 65 call line was also active as 2,388 contracts changed hands.

VIX options are priced off of VIX futures, which suggest that the spot VIX will retreat below 40 but not anytime soon.

March futures finished at 43.15 while April futures stood at 41.60.

(Editing by Jan Paschal)