June 24 (Bloomberg) -- Investors are returning to the options market to hedge against declines in equities amid signs the chance of “large” falls is increasing as the economic recovery falters, according to Morgan Stanley analysts.

Downside skew, which gauges the relative cost of buying insurance against a slide in stocks, is now higher than it was when the Standard & Poor’s 500 Index dropped to a 12-year low on March 9. That indicates a “relatively high chance of downside moves,” the brokerage wrote in a report dated yesterday.

Global equity markets are beginning to falter after three straight months of gains in March, April and May. The S&P 500 has retreated 5.4 percent since June 12, bringing an end to the benchmark’s biggest three-month rally in more than 70 years amid concern the global recession may yet deepen.

“The sharp move higher in risky assets off the early March lows had pushed hedging to the back burner,” a team of analysts led by New York-based Sivan Mahadevan wrote. “Downside skew has risen recently, implying that the probability of large negative moves is actually somewhat higher.”

Option prices have increased in recent days amid signs that the economic recovery may be faltering. The VIX Index, as the Chicago Board Options Exchange Volatility Index is known, has risen 9.3 percent since its June 19 low. Europe’s VStoxx Index, which gauges the price of options on the Dow Jones Euro Stoxx 50 Index, has increased 17 percent since June 11.

Increased Skew

The difference between the cost of put options to hedge against a 30 percent drop in equities and the cost of options to protect against a 10 percent decline is now at its highest since February, the brokerage said. The spread, which is one way of measuring so-called skew, is now higher than it was when the S&P 500 dropped to its lows in March.

“The fact that skew has ticked up in the recent past suggests to us that derivatives users seem to agree that tail risks are still present,” the analysts wrote.

Demand for options has increased in recent weeks amid stock declines in both the U.S. and Europe. The number of open put- option contracts on the S&P 500 surged to the highest since September last week prior to the mid-year options expiry. In Europe, the number of open put-option contracts surged to its highest since December last week.

Call options give the buyer the right to buy shares at a pre-agreed price on or before a set date. Puts give the buyer of the option the right to sell. By selling an option, the investor is taking a bet the contract won’t be exercised, allowing them to keep as profit the price paid for the call or put.

Options are derivatives, or securities that derive their value from an underlying asset, and can be used to protect against a decline or to speculate on the asset’s future value.

To contact the reporter on this story: Gareth Gore in Madrid ggore1@bloomberg.net

Last Updated: June 24, 2009 04:43 EDT