Investors sought protection in options on Wednesday as fears of a U.S. credit rating downgrade intensified.
This week's decline in U.S. stocks has been accompanied by a steady rise in the CBOE Volatility Index .VIX as lawmakers struggle to agree to raise the debt ceiling with less than a week to go before the government hits its borrowing limit.
Wall Street's favorite barometer of anxiety, the VIX, ended 13.59 percent higher to 22.98, the highest in more than a month.
The increase in volatility has been gradual, a sign investors are at present more worried about the United States losing its prized triple-A credit rating than a technical default that could roil markets.
"If there was really concern about a default, the VIX would be higher," said Frederic Ruffy, options strategist for New York-based Web information site WhatsTrading.com.
"Odds are that the government will still pay its debt, even if it is forced to cut spending in other areas."
The VIX is a 30-day risk forecast of stock market volatility implied by S&P 500 index .SPX options prices and often goes up when stocks decline as investors bid up option premiums.
"It appears the VIX is starting to price in the possibility of a credit downgrade for U.S. debt," said Chris McKhann, analyst at Chicago-based website optionMonster.com. "Demand for near-term protection has increased."
Wednesday's rise in volatility is nowhere near as steep as in March after Japan's earthquake and subsequent nuclear crisis or the 80 reading reached during the 2008 credit crisis.
Ruffy noted that this week, overall volume in the S&P 500 Index pits has been light.
But on Wednesday SPX puts have been outpacing calls by a factor of 2.92 to 1, according to options analytics firm Trade Alert, far above the 22-day moving average of that ratio, which is 1.75.
Traders exchanged about 809,000 options in the SPX, above its average daily level of 748,000 contracts, Trade Alert data shows.
Short-term shocks in the equities markets can cause sharp spikes in the VIX. It peaked at 31.28 after the Japanese earthquake and tsunami in March.
In volatility derivatives, the VIX futures are higher, with August and September at 21.30 and 21.75, respectively. Those contracts are trading at a discount to the spot VIX. That suggests that traders expect any turmoil to be short-lived, said McKhann.
VIX call trades have been active this week as traders look to hedge against a sharp move up in volatility. About 385,000 calls and 131,000 puts changed hands in the VIX, Trade Alert data shows.
Traders are bracing for volatility across various asset classes. Call spreads have been active in the SPDR Gold Trust (GLD.P), the world's largest gold-backed exchange-traded fund. Gold fell on Wednesday after hitting record highs near $1,630 an ounce.
In the Financial Select Sector SPDR fund (XLF.P), the option flow was bearish and seemed to reflect increased investor anxiety levels related to the budget stalemate, Ruffy said. About 275,000 puts and 94,000 calls traded in the XLF - a ratio of 2.92 puts for each call, compared with the 22-day moving average of 0.91.
"People are looking or protection by buying puts on both the S&P 500 index and the SPDR S&P 500 Trust (SPY.P)," said Joe Cusick, senior market analyst at online brokerage optionsXpress in Chicago. "They are also buying calls on the SPDR Gold Trust as a potential hedge for a bad outcome."