By Julie Haviv
NEW YORK, Oct 10 (Reuters) - Foreign exchange optionsinvestors remained cautious on Thursday curbing bets that wouldprofit from a stronger dollar as Washington showed some signs ofreaching a temporary deal to reopen the government and avoid adisastrous U.S. default.
The greenback, which had weakened since the U.S. governmentpartially closed on Oct. 1, gained ground on Thursday on signsof progress toward ending the U.S. budget deadlock and debtlimit 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 lastweek, should continue to weaken.
A reflection of the heightened market uncertainty is evidentin one-week euro/dollar risk reversals, a broadgauge of currency market sentiment, which show options investorson Wednesday and Thursday seeking the smallest protectionagainst the euro's depreciation versus the dollar in eightmonths.
Adding momentum, one-year risk reversals showeddemand for euro puts, the right to sell the euro versus thedollar at a future date, not far from Wednesday's level when itreached its smallest since July.
This indicates that bullish dollar sentiment has waned inthe hedge fund sector that largely drives demand for short-termrisk reversals and has broadened to long-term investors.
Options investors are "no longer pricing in a premium fordollar calls, which indicates investors have been buyingprotection against a weaker dollar," said John Hopkinson,foreign exchange and derivatives strategist at BoA Merrill Lynchin New York.
"It is reasonable to assume that a (U.S. debt) default is ascenario that they are concerned about," he said.
A partial U.S. government shutdown is in its second week andthere are only seven days left for Congress to raise the U.S.debt ceiling. Congress must strike a deal by Oct. 17, when thegovernment will run out of money to pay its bills, according toTreasury Secretary Jack Lew.
Indeed, December $1.39 euro calls were actively traded early on Wednesday, according to Matthew Schilling, acommodities broker at RJO Futures in Chicago.
Investors who buy these calls expect the euro to rise abovethat level before they expire in December, far above where theeuro last traded at $1.3528.
Moreover, on Thursday, there were 2.7 euro calls for everyput, above a ratio of 2.4 earlier this week.
"The dollar has got two headwinds going on, one is the debtceiling and the other is the nomination of Janet Yellen as thenext Federal Reserve chief," Schilling said.
U.S. President Barack Obama nominated Fed No. 2 Yellen onWednesday. Investors expect her to tread carefully in windingdown economic stimulus.
The Fed's $85 billion per month bond buying program, calledquantitative easing, is negative for the dollar as it istantamount to printing money.
Should the U.S. default on its debt the "dollar shouldinitially fall precipitously, but would rebound sharply as thesafe-haven flows spark a rush back into dollar denominatedassets," said Brad Bechtel, managing director at Faros Trading,in Stamford, Connecticut.
"First, there will be a large outflow from the U.S. as othermarkets around the world start to falter, but safe-haven bidswill return to the dollar," he said.
In the latest Reuters poll of foreign exchange strategiststhe overwhelming majority forecasted the dollar to rebound overcoming months.
Ken Dickson, investment director of currencies at StandardLife Investments in Edinburgh, Scotland, who helps oversee$271.2 billion in assets, expects the dollar's "outperformanceto re-assert itself" towards the end of the year and through2014.
"The dollar was already attractive on valuation grounds andrecent trading suggests that shorter term players have built upshort dollar positions," he said. "We expect the U.S. economy tooutperform developed economies over the next few quarters, soincoming data now holds the key," to the dollar's direction.
Nevertheless, implied volatility, or "vol", a measure of theoptions market's expectations of price movements, on one-montheuro/dollar implied volatility rose as high as 7.50percent on Wednesday, its highest since early September. OnThursday it dipped to around 7 percent.
"However the tail risk is large and as we move closer tomid-October, vol is likely to increase," making it moreexpensive to hedge currency positions, said Camilla Sutton,chief currency strategist at Scotiabank in Toronto.