UPDATE 1-Demand for protection against U.S. equity selloff soars to record

Fri Jan 24, 2014 3:52pm EST

* January call options on VIX hit record 8.4 million contracts

* Spread between VIX and three-month VIX futures briefly turns negative

* CBOE VIX up 43.5 percent for the week but still below long-term average (Updates with CFTC data; updates prices)

By Angela Moon

NEW YORK, Jan 24 (Reuters) - Demand for protection against a U.S. stock-market selloff soared on Friday as traders scooped up call options in CBOE Volatility index VIX, Wall Street's favorite index of anxiety.

January call options - contracts betting on the rise of the underlying security - on the VIX this week rose to a record 8.4 million contracts at the Chicago Board Options Exchange while the index itself jumped nearly 30 percent on Friday and about 44 percent for the week.

Since the VIX usually moves inversely to the performance of the S&P 500 stock index, traders often use the index to hedge against a market decline.

Reflecting the surge in demand for short-term protection, the spread between the VIX and three-month VIX futures briefly turned negative on Friday. Generally, due to the mean-reverting nature of the VIX, when the VIX is low, VIX futures trade at a premium.

"We haven't had a correction for a while now, and while I think the market is overreacting a bit, concerns about China and other emerging market equities and currencies are weighing," said Randy Frederick, managing director of active trading and derivatives at Charles Schwab in Austin, Texas.

"Looking at the implied volatility of VIX calls versus VIX puts, it's relatively cheaper to buy VIX calls now so it's a good time to buy (VIX calls) if you think it's headed higher."

Wall Street was closing out its worst week since June 2012, weighed by concerns about growth in China that fed a broad selloff across the globe, but particularly in emerging markets. The S&P 500 is down 2.3 percent so far this week.

Reflecting the recent bearish sentiment in equities, fund managers cut their net long positions in S&P 500 futures contracts in the week ended Jan. 21 by 1,024 to 224,255, U.S. Commodity Futures Trading Commission data showed on Friday.

While the VIX is at its highest since October, it is still way below its 20-year average of 20.50.

Along with the spike in VIX, VIX-related exchange-traded products also jumped including the iPath S&P 500 VIX short-term futures exchange-traded note VXX and ProShares UltraPro Short Russell2000 exchange-traded fund UVXY, up 9.8 percent and 19.9 percent, respectively.

The iPath VIX ETN tracks activity in near-term futures contracts and is a way to bet on volatility without actually buying options. With more than 47 million shares traded Friday, it was the third-most active exchange-traded product on U.S. exchanges.

STILL A LONG WAY TO GO

Earlier this week, a trader was reported to have paid 90 cents for 90,000 May expiration call options at the 23 strike on the VIX index. Considering that the index was below 13 at that time, the trader was betting the VIX to roughly double by May. On Friday, premiums on the May call options were centered around $1.10 per contract.

"While that's a decent gain from its purchase price, we can't help but feel as though traders are still assigning relatively low likelihood to a sustained rebound in volatility," said Andrew Wilkinson, chief market analyst at Interactive Brokers in Greenwich, Connecticut.

"Maybe that is because in the last year the VIX index has only traded above a 20 reading on about five occasions. And so while the market may be running scared again today, option traders are not yet willing to throw in the towel on the bull market," he said.

Other notable trade on the VIX for the day was a 33,000-lot of Feb 19 calls for 59 cents, according to WhatsTrading.com options strategist Frederic Ruffy. The most active options were the Feb 14 puts, Feb 22 calls, and Feb 16 calls.

As of the afternoon session on Friday, 460,000 calls traded, exceeding the recent average daily volume of 454,000 contracts, while 190,000 puts traded, compared to the daily average of 140,000 contracts. (Reporting by Angela Moon; Editing by James Dalgleish)

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