Fear indicator spikes as traders get ‘skittish’

Market fear is on the rise. The CBOE Volatility Index is up 40 percent on the week, which indicates that investors are paying more to get protection against the market. And options traders appear to believe that the fear surge isn't over yet.

As stocks slid on Monday,Tuesday and Wednesday, the volatility index (known as the VIX) has risen precipitously. And while the VIX and the S&P 500 do enjoy an inverse relationship, given that options prices rise when investors seek protection, traders say the VIX has risen far more than might be expected based on the market decline alone.

Investors have become "more skittish than they have been throughout most of 2014," said Russell Rhoads, a VIX expert with the CBOE's Options Institute.

This can also be seen in options activity on the VIX.

In the week up to Wednesday at noon ET, some 45,000 of the December 20-strike VIX calls have traded, many of these on Tuesday. These bets will expire worthless unless the VIX rises from current levels around 16.50 to 20 (the famous long-term average for the VIX) by the opening of the market on Wednesday, Dec. 17.

And on Wednesday morning, the single-largest trade on any index (in terms of number of contracts) was the purchase of 9,900 VIX 16-strike calls at a price of 97 cents (for a total of slightly less than $1 million in options premium).

Read MoreLouise Yamada: Here's how far the S&P will fall

Traders work on the floor of the New York Stock Exchange on the morning of November 28, 2014 in New York City.
Getty Images
Traders work on the floor of the New York Stock Exchange on the morning of November 28, 2014 in New York City.

For trades such as this to pay off, the VIX would need to continue to rise through Wednesday morning. This even though few catalysts for a fear spike are in sight. Indeed, the much-watched Federal Reserve decision comes next Wednesday afternoon, after these options expire.

Some traders are taking advantage of the fear. Because he's heard that some traders are buying options not because they actually believe the VIX will spike, but due to pressure from a major clearing firm that's worried about VIX exposure all the way up to 40, Brian Stutland of Equity Armor Investments has elected to start selling upside VIX calls.

Some of the options being bought "have no chance of finishing in the money," he told CNBC. "I sold the 27-strike call for a nickel."


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