By Julie Haviv
NEW YORK, Oct 10 (Reuters) - Foreign exchange options investors remained cautious on Thursday curbing bets that would profit from a stronger dollar as Washington showed some signs of reaching a temporary deal to reopen the government and avoid a disastrous U.S. default.
The greenback, which had weakened since the U.S. government partially closed on Oct. 1, gained ground on Thursday on signs of progress toward ending the U.S. budget deadlock and debt limit deadline in Washington.
But if politicians fail to be forge an agreement, the U.S. currency, which hit an eight-month low versus the euro last week, should continue to weaken.
A reflection of the heightened market uncertainty is evident in one-week euro/dollar risk reversals, a broad gauge of currency market sentiment, which show options investors on Wednesday and Thursday seeking the smallest protection against the euro's depreciation versus the dollar in eight months.
Adding momentum, one-year risk reversals showed demand for euro puts, the right to sell the euro versus the dollar at a future date, not far from Wednesday's level when it reached its smallest since July.
This indicates that bullish dollar sentiment has waned in the hedge fund sector that largely drives demand for short-term risk reversals and has broadened to long-term investors.
Options investors are "no longer pricing in a premium for dollar calls, which indicates investors have been buying protection against a weaker dollar," said John Hopkinson, foreign exchange and derivatives strategist at BoA Merrill Lynch in New York.
"It is reasonable to assume that a (U.S. debt) default is a scenario that they are concerned about," he said.
A partial U.S. government shutdown is in its second week and there are only seven days left for Congress to raise the U.S. debt ceiling. Congress must strike a deal by Oct. 17, when the government will run out of money to pay its bills, according to Treasury Secretary Jack Lew.
Indeed, December $1.39 euro calls were actively traded early on Wednesday, according to Matthew Schilling, a commodities broker at RJO Futures in Chicago.
Investors who buy these calls expect the euro to rise above that level before they expire in December, far above where the euro last traded at $1.3528.
Moreover, on Thursday, there were 2.7 euro calls for every put, above a ratio of 2.4 earlier this week.
"The dollar has got two headwinds going on, one is the debt ceiling and the other is the nomination of Janet Yellen as the next Federal Reserve chief," Schilling said.
U.S. President Barack Obama nominated Fed No. 2 Yellen on Wednesday. Investors expect her to tread carefully in winding down economic stimulus.
The Fed's $85 billion per month bond buying program, called quantitative easing, is negative for the dollar as it is tantamount to printing money.
Should the U.S. default on its debt the "dollar should initially fall precipitously, but would rebound sharply as the safe-haven flows spark a rush back into dollar denominated assets," said Brad Bechtel, managing director at Faros Trading, in Stamford, Connecticut.
"First, there will be a large outflow from the U.S. as other markets around the world start to falter, but safe-haven bids will return to the dollar," he said.
In the latest Reuters poll of foreign exchange strategists the overwhelming majority forecasted the dollar to rebound over coming months.
Ken Dickson, investment director of currencies at Standard Life Investments in Edinburgh, Scotland, who helps oversee $271.2 billion in assets, expects the dollar's "outperformance to re-assert itself" towards the end of the year and through 2014.
"The dollar was already attractive on valuation grounds and recent trading suggests that shorter term players have built up short dollar positions," he said. "We expect the U.S. economy to outperform developed economies over the next few quarters, so incoming data now holds the key," to the dollar's direction.
Nevertheless, implied volatility, or "vol", a measure of the options market's expectations of price movements, on one-month euro/dollar implied volatility rose as high as 7.50 percent on Wednesday, its highest since early September. On Thursday it dipped to around 7 percent.
"However the tail risk is large and as we move closer to mid-October, vol is likely to increase," making it more expensive to hedge currency positions, said Camilla Sutton, chief currency strategist at Scotiabank in Toronto.