Wall Street fear gauge pops up as US stocks slump

*CBOE fear gauge spikes up as U.S. stocks decline

*VIX options turn busy on bets volatility will return

By Doris Frankel

CHICAGO, April 20 (Reuters) - The sharp decline in U.S. stocks drove the Chicago Board Options Exchange Volatility Index .VIX up more than 15 percent on Monday as investors, worried over the health of the financial sector, clamored for protection to insure their stock portfolios.

The VIX, often called Wall Street's fear gauge, vaulted to 39.22, up 15.56 percent, its largest daily percentage gain since Jan. 20.

On Friday it had ended at its lowest level since last September at 33.94 as historic volatility levels were on the decline, analysts said.

"The VIX is up on investors' increased concerns over the state of the financial sector, resulting in raised option premiums," said Andrew Wilkinson, senior market analyst at Connecticut-based Interactive Brokers Group.

Bank stocks, already lower after a surge in troubled loans at Bank of America Corp (BAC.N: Quote, Profile, Research, Stock Buzz) overshadowed its better-than-expected earnings, led the march lower in the broad market.

Shares of Citigroup Inc (C.N: Quote, Profile, Research, Stock Buzz) fell more than 20 percent after Goldman Sachs said credit losses at the bank continued to grow at a rapid rate, putting a damper on earnings expectations.

The Select Sector SPDR Financial exchange traded fund XLF.P was also down 8.82 percent to $10.13.

Investors are increasing their hedges following a steep drop in the XLF as well as notable declines in the housing and consumer discretionary sectors, said Scott Fullman, director of derivative Investment Strategy at New York-based broker-dealer WJB Capital Group.

Investors are also awaiting results on stress tests on the health of major banks and also potential legislation with respect to credit card policies, Fullman said.

The Obama administration has said the results of "stress tests" would be released on May 4.

The VIX, calculated from Standard & Poor's 500 index .SPX options, tracks the market's expectations of future volatility over the next 30-day period. It often moves inversely to the S&P benchmark, and goes up as option premiums are raised.

The fear index is now heading back toward the 20-day moving average of 40.02, Fullman said.

In VIX options, which are priced off VIX volatility futures, investors were keen to sell declining put premiums on the likelihood that fear has returned, Wilkinson said.

Put volumes at the 30, 32.50 and 35 strikes expiring next month were relatively high before call buyers emerged on the upside at VIX strikes between 42.50 and 55, he said.

"If the VIX remains elevated, the value of those VIX puts sold today will quickly erode, allowing short sellers to close their positions at a profit," Wilkinson said.

(Reporting by Doris Frankel, Editing by Chizu Nomiyama)