Options fear gauge spikes to near three-month high

By Doris Frankel

CHICAGO, June 7 (Reuters) - Options traders turned defensive on Thursday as they scrambled after put insurance on many stock market indexes to take some risk off the table.

The demand for protective options was triggered by a meltdown in U.S. stock indexes, which are under pressure for the third straight day after a sharp jump in Treasury debt yields ignited investors' concerns about inflation and higher interest rates.

That sent the Chicago Board Options Exchange, or VIX .VIX -- known as Wall Street's fear gauge -- to its highest level since mid-March. The VIX, which measures projected stock market volatility embedded in near term Standard & Poor's 500 .SPX, surged 11.90 percent to 16.61, after posting a session high of 17.09 late on Thursday.

The direction of interest rates was the catalyst for investors' jitters, leading to an increase in option prices.

"The threat of higher rates has led to a rise in actual volatility and volatility perceptions," said Frederic Ruffy, an analyst at options education firm Optionetics in Redwood City, California.

The VIX typically runs counter to the S&P benchmark, rising when there is a state of nervousness, as is often sparked by a stock market decline. This prompts investors to seek portfolio protection in the form of index options, allowing them the right to sell or buy the security at a preset price and time.

Defensive option action was seen in a number of other index products, including exchange traded funds Diamond Trust Series 1 DIA.N, which tracks the Dow Jones industrial average .DJI, where 60,000 puts traded and the iShares Russell 2000 Index Fund (IWM.P) as 370,000 puts versus 115,000 calls changed hands, according to Optionetics data.

Also on Thursday, the Nasdaq 100 Index Tracking Stock, or QQQQs (QQQQ.O), roughly 450,000 puts compared to 183,000 calls traded late in the day.

The Standard & Poor's 500 Depositary Receipt SPY.A, more popularly known as Spiders, saw the most aggressive put action late on Thursday as more than 550,000 puts compared with 115,612 calls crossed the tape for a ratio of more than 4 puts for every call, Optionetics figures showed.

Most of the volume was in the June and July contracts as portfolio managers sought short-term protection from a further market pullback, Ruffy said.

"This may be the time that we are potentially seeing the makings of a 10 percent or more normal correction in a bull market -- something we have not seen in the last couple of years," said Herb Kurlan, president of Vtrader Pro, an online trading firm in San Francisco.

"So it's not surprising to see the market using this as a period to take a breather from this sustained bull market that we have had been enjoying since August 2006," Kurlan added.

Most managers have added a massive amount of long exposure over the past couple of months on their books in an attempt to keep up with the averages," said Kyle Rosen, president of Rosen Capital Management, an options hedge fund in California.

"So they are more exposed to the long side now than they have been in years," Rosen said. "That creates a vulnerable situation, and any market weakness tends to increase demand for put options so these long managers can protect themselves."