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Soaring VIX Index May Signal More Trouble Ahead for Stocks

Europe's spreading debt crisis—combined with an overdue stock pullback and the prospect of the Federal Reserve withdrawing its economic support—added up to one thing Tuesday: Fear.

As the Dow Jones industrial average tumbled more than 200 points and safe-haven moves for US Treasurys escalated, investors sought protection with the Chicago Board Options Exchange's Volatility Index, which soared as much as 27 percent in heavy trading.

The VIX allows investors to buy options protection against market tumult, and they took full advantage as the financial markets thundered. Tuesday marked the third straight triple-digit move in the Dow.

"When the stock market does this in conjunction with a flight to safety in bonds and a flight to safety in the dollar and the yen, then you should expect a jump in the volatility index," said Andrew Wilkinson, senior strategist at Interactive Brokers. "So we've got a nasty mix of so many different variables today, each from a different part of the globe, that's making for difficult navigation in stormy waters."

Stocks and the VIX tend to move in opposite directions, and Wilkinson said traders were leaning heavily toward calls on the index, which would indicate a trend higher in volatility.

Investors have used similar market drops in recent months as buying opportunities. But with a fresh set of concerns and persistent calls for a correction that has yet to materialize, this time could be different.

"Europe and the euro is kind of the tip of the iceberg of bigger issues, which is worry over sovereign debt and currencies," said Nicholas Colas, chief market strategist at ConvergEx Group in New York. "That's something the market and euro have gotten a huge pass on."

The spike in volatility, then, could be a warning sign that investors will have to change their strategies as global risk intensifies.

"So many people have been trained to buy on the dips. What we're afraid of is this is a game of musical chairs," said Kathy Boyle, president of Chapin Hill Advisors in New York. "One of these times it's just not going to work."

The main driver of Tuesday's stock market plunge seemed to be growing worries that Greece's debt crisis would spread to Spain and Portugal, despite the euro zone's pledge of rescue funds.

The corresponding flight to safety pushed up the US dollarwhich in turn weighed on stocks, which have performed better on a weak currency since the financial crisis began.

"People are building in a lot more uncertainty and buying some level of protection with a lot of the equity markets around the globe rolling over," said Dave Lutz, managing director of trading at Stifel Nicolaus in Baltimore. "There's a variety of things that are concerning people right now, including Greece. What's more important is what's in line after Greece."

Other volatility trackers indeed suggest that investors are concerned over what lies ahead.

The medium-term volatility measure, the iPath S&P 500 VIX Mid-Term Futures, which looks out four to seven months, was up a comparatively modest 5 percent in mid-day trading. But a shorter-term measure, the iPath S&P 500 VIX Short-Term Futures exchange-traded note, , which goes out one to two months, gained 10 percent.

Both measures reflect sentiment that the concern stretches beyond the day's trading.

Investors worried separately about the euro zone problems, whether stocks were ready to pull back—and how the removal of Fed's liquidity measures would affect the markets. Minutes from the Fed's most recent meeting are due to be released Wednesday, while leigslators vote on financial reform that could dramatically change the way banks do business.

"People are concerned structurally because they're buying protection farther out on the curve," said Rick Bensignor, chief market strategist at Execution Noble in New York. "Europe is certainly the catalyst, but it depends on how much banking reform affects the market."

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