Options fear gauge jumps ahead of key jobs data

    By Doris Frankel 16:58 02Jul2008

CHICAGO, July 2 (Reuters) - The Chicago Board Options Exchange Volatility Index <.VIX> rose sharply on Wednesday with options traders on the defensive a day before a key monthly jobs report.

    The VIX, often referred to as Wall Street's fear gauge, jumped 9.60 percent to close at 25.92, its best level since March 31 as U.S. stocks tumbled.

    "We have lots of negative influences coming together at the end of the day," said Frank O'Connor, director of online broker-dealer Zecco Trading.

    Data released on Wednesday showed U.S. private employers slashed 79,000 jobs in June. The ADP data raised expectations for an even more disappointing government nonfarm payrolls report.

    "There are concerns over Friday's payroll numbers, which could be worse that expected. Investors are bidding up options to reflect the uncertainty in the market," O'Connor said.

    Trading is likely to be thin on Thursday due to the July 4 holiday on Friday when financial markets are closed and that could exacerbate some post-payroll market volatility, said options strategist Frederic Ruffy at web information site WhatsTrading.com.

    Worries about credit, the economy and rising oil prices also appeared to be dominating the stock market at the start of the second half of the year, said Scott Fullman, director of derivative investment strategy at broker-dealer WJB Capital Group.

    The VIX, which measures projected stock market volatility embedded in near-term Standard & Poor's 500 Index <.SPX> option prices, typically runs inversely to the benchmark, which closed at 1,261.52, down 1.82 percent.

    It rises when anxious investors are inclined to bid up options to guard their portfolios against uncertainty.

    But the VIX is far from its March 2008 peak of 35.60 when the S&P 500 sold off sharply on uncertainty about how far the credit crisis might go after JPMorgan's deal to buy investment bank Bear Stearns.

    Many market observers are still wondering over the absence of a more sizable gain in the VIX that would put some kind of timeline on a recovery in the S&P 500, said Rebecca Engmann Darst, equity options analyst at Interactive Brokers Group.

    "A spike in the VIX often signifies a market bottom but the recent grind lower in U.S. shares has presented a different set of circumstances for volatility traders to contend with," Darst said.

    On the options front, out-of-the-money VIX call action predicting such a spike in the VIX has been mixed.

    The number of contracts outstanding in the July VIX calls at strikes 25, 27.50 and 30 have all risen by 21 percent this week, suggesting traders are sitting tight on positions predicting more stock market swings after the July 4 weekend, Darst said.

    Earlier in the session, an unusual multi-leg option trade called a butterfly was apparently transacted. It involved 2,000 lots at the VIX 20 and 30 call strike and 4,000 lots at the 25 call strike in the July and August contracts, according to Interactive Brokers data.

    Traders buy VIX calls in anticipation of more stock turbulence.

    Rather than buying VIX calls wagering on a spike higher in the VIX, this trader appears to be looking for a big move up or down away from the 25 strike, essentially betting on volatility in the volatility index, Darst said.