Volatility index below 30 for 1st time since Sept

* Volatility index dips below 30 for first time in 8 mths

* Large number of VIX May calls likely to expire worthless (Adds byline, analyst comments, VIX expiration)

By Doris Frankel

CHICAGO, May 19 (Reuters) - A key measure of market volatility dropped to levels not seen since the collapse of Lehman Brothers, suggesting investors are much less worried about sharp swings in equity prices.

The Chicago Board Options Exchange Volatility index .VIX, commonly known as the market's "fear gauge," fell below the key 30 level on Tuesday for the first time in eight months.

The decline in the anxiety that dominated trading through the latter half of 2008 into early 2009 suggested investors no longer see the need to guard as heavily against the potential for unexpected gyrations in shares.

The VIX hit a session low of 28.88, off 4.5 percent, its lowest level since Sept. 19, 2008. It sank to 30.24 on Monday, its lowest close since Sept. 12, 2008.

"We have seen a major correction in volatility following the 39 percent rise in the S&P index from the March lows, and there is rising confidence that we will not test those lows again, as illustrated by the decline in the VIX," said Scott Fullman, director of derivative investment strategy at New York-based broker-dealer WJB Capital Group.

RETURN TO PRE-LEHMAN LEVELS

The VIX, calculated from Standard & Poor's 500 index .SPX option prices, tracks the market's expectation of future volatility over the next 30-day period and often moves inversely to the S&P benchmark.

The index has closed above 30 every day since Sept. 12, 2008, the Friday before the fateful weekend when Lehman Brothers Holdings Inc (LEHMQ.PK) imploded and the government intervened to bail out insurer American International Group Inc (AIG.N).

It hit an intraday peak of 89.53 on Oct. 24, 2008, and closed at a high of 80.06 on Oct. 27, as investors reacted to frozen credit markets by buying protection against broad-market declines.

The index started to retreat after testing highs in the 80 level back in November 2008. During the first quarter of 2009, the VIX spent most of its time in a 38-to-53 range and then began to set a series of lows after April 9.

BUTTERFLY EFFECT

Many in the options market did not expect such a dramatic drop. More than 650,000 out-of-the-money VIX May call options, nearly half the open interest in the product, are likely to expire worthless. May VIX options and futures expire Tuesday with settlement Wednesday morning.

Most of the positions were purchased in large sizes in mid-March on the assumption that the increased volatility would persist. They were constructed as 35-45-55 May call butterfly spreads, which involves buying call options at strikes of 35 and 55 and selling calls at the 45 strike.

In that particular butterfly spread, an investor expected the VIX to converge on the 45 level. Such a bet implies expectations that the market would remain jittery.

"The rationale behind the butterfly spread trade is that market volatility would remain high, and that May VIX futures would settle at or around an index level of 45 at expiration," said Andrew Wilkinson, senior market analyst at Interactive Brokers Group.

For the past several years, 30 was a key marker on the VIX. Often, when the index would creep above that level, it was a sign of excessive fear, and the stock market responded with a rally on several occasions.

"After a very volatile period in the final months of 2007 and early 2008, the broader economic outlook has stabilized, which has resulted in lower levels of volatility in the equity market," said Frederic Ruffy, options strategist at Web information site WhatsTrading.com. (Reporting by Doris Frankel, additional reporting by David Gaffen in New York; editing by Jeffrey Benkoe)