CHICAGO, Oct 28 (Reuters) - The Chicago Board Options Exchange Volatility Index .VIX, Wall Street's so-called fear gauge, fell sharply on Tuesday, in a sign that investors had little incentive to seek protection after U.S. stocks rallied.
The VIX, the implied volatility measure for the Standard & Poor's 500 index .SPX options, dropped 16.36 percent to 66.96 as the S&P benchmark soared more than 10 percent to 940.51.
The VIX had closed at a record high of 80.06 on Monday. But it had a tough time sustaining that level on Tuesday and started to drop rapidly as soon as the market showed any kind of strength.
"This is an impressive smashing of the VIX," said Joe Kinahan, chief derivatives strategist at online brokerage firm thinkorswim Group in Chicago.
"The VIX is down due to the fact that investors are not willing to pay as much for protection in the form of options as they were in the last few weeks," he said.
Investors snapped up stocks beaten down in recent sessions, while optimism grew that the U.S. Federal Reserve and other central banks would cut interest rates further.
"Stability has not only come to the U.S. but to foreign markets. The threat of further calamity seems less likely," Kinahan said.
At a near 67 reading, the VIX is significantly below the near-term actual volatility level for the S&P 500 benchmark.
The 20-day statistical volatility of the S&P 500 stood at 77.3 percent, down from 82.2 percent on Friday, according to Frederic Ruffy, options strategist at New York-based Web information site WhatsTrading.com.
Ruffy said it may be a sign that players in the options market believe the period of extreme volatility has passed and a more orderly trading environment could be in the cards for November.
A recovery in Asian equity markets overnight and a rise in European shares sowed optimism, along with signs of a further thaw in the credit markets. The rates banks charge each other to borrow funds in euros, the dollar and sterling fell.
The Federal Reserve, which started a two-day policy setting meeting on Tuesday, is expected to announce on Wednesday a cut in the benchmark federal funds rate of at least 50 basis points from the current 1.5 percent rate.
"We should be seeing volatility in the 40 to 50 range very soon, depending on the Fed action tomorrow and a continuation of the financial markets being able to interact with each other," said Herb Kurlan, chief executive of Vtrader Pro, a proprietary online trading firm in San Francisco.
But he cautioned there is still a lot of uncertainty.
"It has not been cleared up with a one market rally," he said. "So support in the VIX is probably around the 30 level compared to its traditional mean of a 17 to 20 reading." (Editing by Leslie Adler)