Option fear gauge drops as Fed move sparks gains

CHICAGO (Reuters) - The Chicago Board Options Exchange Volatility Index, Wall Street's main barometer of investor fear, fell sharply on Tuesday after the Federal Reserve cut a key U.S. interest rate and stronger-than-expected earnings results from two investment banks calmed credit concerns.

The VIX, as it is often called, closed at 25.79, down 20.01 percent, its biggest one-day percentage loss since mid-November 2007 and the fourth biggest daily drop in the past 14 years.

The decline in the volatility index comes one day after it hit a five-year closing high of 32.24 and one day ahead of VIX options expiration.

The VIX has been on the rise after the collapse of Bear Stearns Cos Inc which stunned Wall Street and pummeled financial stocks on the eve of an expected U.S. interest rate cut.

The financial sector had been in the spotlight by investors after JPMorgan Chase & Co agreed over the weekend to buy stricken Bear Stearns for $2 per share with the backing of the Fed.

But after the Fed's interest rate cut, many financial stocks, including some of the biggest losers in the subprime mortgage meltdown, were top gainers on the New York Stock Exchange.

Traders believe stability is returning, and will likely reduce their option hedges, said Kyle Rosen, president of Rosen Capital Management, a California-based options hedge fund.

U.S. stocks surged helped by stronger-than-expected quarterly results from Goldman Sachs and Lehman Brothers. They extended their gains after the central bank slashed rates by 75 basis points to 2.25 percent, its lowest level since February 2005, in a move aimed to hold off a deep recession.

"The Fed has reassured investors to the extent that volatility will go down," said Herb Kurlan, chief executive of VTrader Pro LLC, a broker-dealer in San Francisco.

The Fed action over the weekend and the reduction of interest rates combined with the relatively positive earnings reports from Lehman and Goldman, gave investors assurance that they can come back into the market, he said.

"Investors can now refocus on buying or selling stocks based on the fundamentals, rather than looking over their shoulders and worry about the next company suddenly going out of business," Kurlan said. "So the demand for put options which drive volatility has been abated for the time being."

The VIX, which measures projected stock market volatility embedded in near-term S&P 500 option prices, is a contrarian indicator and generally moves opposite to the index.

"With little else on the economic calendar over the next two days along with the recent rebound in the financials, the VIX might drift lower still, now that an important event risk has passed," said independent options trader Frederic Ruffy.

(Reporting by Doris Frankel; Editing by Diane Craft)