Wall St's fear gauge lights up as U.S. stocks slide

By Doris Frankel

CHICAGO (Reuters) - The Chicago Board Options Exchange Volatility Index .VIX jumped on Tuesday, suggesting that many investors are buying options to manage their stock market risk as U.S. stocks tumbled.

"A combination of pre-earnings angst, higher energy prices, and worries about credit problems have driven risk perceptions sharply higher," said Frederic Ruffy, analyst at Optionetics, an options education firm in Redwood City, California.

Commonly called Wall Street's fear gauge, the VIX often rises to indicate participants are bidding up index options as they become more nervous about the market.

The indicator surged 15.90 percent to end the day at 17.57, its highest level since June 27. It rose above 17.24 only twice last month, on June 26 and June 27.

The VIX, which measures anticipated stock market volatility conveyed in Standard & Poor's 500 .SPX index options, typically runs in the opposite direction of the S&P benchmark.

It rose early on Tuesday to greet the start of earnings season as U.S. stocks fell.

"This is a very important earnings cycle and investors could be utilizing options to offset losses in their portfolios," said Joseph Cusick, senior market analyst at online brokerage firm optionsXpress Inc.

Profit warnings from retailers Sears Holding Corp. (SHLD.O), Home Depot Inc. (HD.N) and home builder D.R. Horton Inc. (DHI.N) rattled investors and set the stage for early stock market weakness.

"Investors may have begun to limit the downside of their existing positions in other major retailers by buying put protection," said Daryl Nanes, principal of Nanes Delorme Capital Management, a New York-based broker-dealer.

"But despite today's huge move in the VIX, the index still remains historically low, keeping the cost of downside protection still relatively cheap," Nanes added.

Another contributing factor was that crude oil prices were "stubbornly" higher and within striking distance of $73 a barrel, Optionetics' Ruffy said. On the New York Mercantile Exchange August crude settled up 62 cents at $72.81 per barrel.

Financial stocks also took a hit after Standard and Poor's said it might downgrade up to $12 billion in bonds backed by subprime mortgages.

SIGNS OF VOLATILITY RUN

Tuesday's volume on VIX options totaled 154,677 contracts, with calls trading at more than twice the volume of puts, according to market research firm Track Data.

Investors often buy VIX calls in anticipation of stock market volatility and VIX puts on the perception that the market is turning toward more complacency.

"Floor sources indicate to us that July and August calls were well bid up to the 22.5 strike, an upward move of 30 percent, positioning in anticipation of continued high volatility and a sour earnings season," said Andrew Wilkinson, senior market analyst at Interactive Brokers Group.