Options fear gauge lights up, traders play defense

16:49 06Nov2008

(Recasts, updates VIX for close)

By Doris Frankel

CHICAGO, Nov 6 (Reuters) - Option traders were on the defensive on Thursday as Wall Street stocks sold off again in the worst two-day slide since October 1987 amid concerns about a deepening economic downturn.

That sent the Chicago Board Options Exchange Volatility Index, or VIX <.VIX>, Wall Street's so-called fear gauge, up 16.72 percent to 63.68 after rising to a session high of 64.78.

The VIX measures projected stock market volatility conveyed by near-term Standard & Poor's 500 index <.SPX> options prices and typically moves inversely to the benchmark.

"We are seeing a demand for put options ranging across stocks, indexes and even the exchange-traded funds that track major stock benchmarks," said Scott Fullman, director of derivative investment strategy at broker-dealer WJB Capital in New York.

For example, trading in the S&P 500 picked up with about 568,000 puts and 290,000 calls, according to option analytics firm Trade Alert.

With anxiety high ahead of a key jobs report, the fear index remains at lofty levels even though it is down significantly from its October record peak of 89.53.

It crossed back above the 60 reading after bouncing off the 50-day moving average of 44.48 on Tuesday.

The VIX is higher after two days of heavy selling in the equity markets dashed hopes for a return to more normal or quiet trading during November, said Frederic Ruffy, options strategist at Web information site WhatsTrading.com.

The elevated VIX is also a reflection of the high levels of actual volatility, with the 20-day statistical volatility of the S&P 500 now at 85.2 percent, Ruffy said.

Fundamentally, the concerns about the economy were reinforced by poor retail sales numbers. "And expectations for the holiday shopping season now appear under firmer pressure," Fullman said.

Retail chains posted the worst October sales results in more than three decades as consumers sharply cut spending.

Wary investors looked ahead to Friday's October U.S. employment report, which is expected to further underscore the faltering economy after weekly jobless claims fell. The median forecast in a Reuters poll is a fall of 200,000 jobs last month.

Last week efforts by central banks and governments to ease credit strains began to bear fruit for U.S. stocks. Bargain hunting and funds buying stocks to rebalance their portfolios also helped boost equities.

But the option market was wary of the recent stock rally. "This was reflected in the steepness of S&P 500 skew, the price difference between the out-of-the-money put options compared to the out-of-the-money call options on the S&P 500," said Credit Suisse equity derivatives strategist Sveinn Palsson.

Palsson also pointed out that the premiums in the longer-dated S&P options have stayed relatively firm, indicating the option market is expecting a high level of volatility going forward.

"While many stocks are trading at cheap valuations, relative to past earnings, a significant downside risk in equities remains, as the focus returns to the health of the global economy and earnings guidance," he said.

(Reporting by Doris Frankel; editing by Gary Crosse)