LONDON (Reuters) - A host of problems facing Britain's pound has triggered a flare in activity in the usually sleepy sterling options market as nervous investors seek protection against further sharp falls in the currency.
A dramatic pick-up in demand for sterling implied volatility -- a measure of expected price swings -- suggests investors are worried the pound's recent steep slide has further to go.
One-month euro/sterling implied volatilities posted their biggest monthly rise since 2008 in January, jumping to 7.9 percent from around 4.75 percent at the start of 2013.
Risk of recession and a credit rating downgrade, speculation about more monetary easing and growing uncertainty over the UK's relationship with the European Union are some of the negatives stacking up against sterling.
The pound has been one of the biggest losers in 2013, falling more than 5 percent against the euro and 3 percent against the dollar.
While some strategists have cautioned sterling losses could slow given the rapid pace of the pound's recent dive, many market players were wary of more weakness ahead.
"Why buy the pound at the moment?" said Neil Mellor, currency strategist at Bank of New York Mellon. "You don't try to catch a falling knife."
Euro/sterling one-month risk reversals, which measure the relative demand for options on the euro rising or falling against the pound, flipped last month in favour of euro calls -- bets the single currency will rise.
It is the first time risk reversals have shown a bias towards euro strength since June 2011.
The shift to bets on euro gains reflects investors' belief that the worst of the debt crisis has passed, leading some who last year bought UK assets, such as government bonds, as a shelter safe haven from the euro zone reverse those flows.
Sterling's problems, on the other hand, are mounting.
Britain is teetering on the brink of a third recession since the global financial crisis, just as the U.S. economy looks to be picking up and worries about the euro zone recede.
With growth struggling, the coalition government is beset by political wrangling and falling behind its deficit targets. This has fanned concerns Britain will lose its triple-A credit rating, which would probably prompt a wave of sterling selling.
Investors see a risk the Bank of England may opt for more monetary easing to boost growth, and there is uncertainty over what policies incoming governor Mark Carney will adopt when he takes the helm in the July.
More turmoil is in prospect after Prime Minister David Cameron's pledge to hold a referendum on Britain's membership of the European Union in 2017, if his Conservative party wins the next election.
These concerns are driving investors like hedge funds to bet on more big falls in the pound, especially against the dollar.
One-month sterling/dollar implied volatility has jumped to 6.9 percent, from around 4.4 percent on mid-December. One-year implied volatility is even higher around 8.0 percent, reflecting expectations of more sharp moves later in the year.
Positioning data also shows speculators have halved long sterling positions to 17,938 in the week ending January 29 from a month earlier.
Some strategists even anticipate a break through the lower end of the $1.52 to $1.64 trading range in which the pound has been moored in since August 2011.
Stephane Gaillard, head of the Euro FX options book at Nomura, reported hedge fund demand for sterling puts -- the right to buy the pound -- at $1.45 in nine months time.
That level was last touched in June 2010 and is 7.6 percent below the current price around $1.57.
Greg Anderson, North America head of G10 strategy at Citi, said even investors who do not necessarily believe sterling will fall so far are buying options as insurance against such a move.
"It seems unfeasible, but it's happening. When you get a surprise like that the vols are going to tick up. People are going to have to buy deep out-of-the-money protection," he said, referring to options far from the spot price.
Moves in the options market have been mirrored by a number of banks revising lower their sterling/dollar forecasts. Strategists at Deutsche Bank, BNY Mellon and UniCredit all see the pound breaking below $1.52 in 2013.
Editing by Nigel Stephenson