* One-month risk reversals show bias for more euro weakness
* Demand for sub-$1.30 euro/dollar strikes increase
* Some likelihood of $1.28 over next month - traders
* Hedge funds main buyers of downside euro/dollar strikes
Fleet-footed investors, including hedge funds, are betting in the options market that the euro still has some way to fall after political instability in Italy sparked worries about a flare-up in the debt crisis.
Options traders cited growing demand for one-month euro puts -- bets the currency will weaken -- exercisable at $1.28, suggesting the single currency could fall against the dollar to levels not seen since November, within a month or even sooner.
Traders said large hedge funds have been the main buyers of options betting on a lower euro against the dollar.
"Large funds started (buying) even before the Italian elections, so it is more or less a free trade for them now, with spot (levels) here," Martyn Harrison, FX options trader at Marex Spectron, a London-based trading house.
Just a month ago, the markets showed investors betting on short-term euro gains after the European Central Bank turned cautiously optimistic about the euro zone's prospects.
The euro hit a 15-month high above $1.37 on Feb. 1, helped in part by slightly tighter liquidity conditions after European banks repaid cheap loans taken earlier. That saw the ECB's balance sheet contract at a time when both the Federal Reserve, Bank of Japan and the Bank of England were expanding theirs, giving the euro a fillip.
But all that seems to have changed, having fallen this week from a high of $1.3175 on Monday to below $1.30 on Friday.
One-month euro/dollar implied volatility -- a gauge of expected market moves and key to option pricing derived from options prices -- jumped to 10.1 percent on Tuesday, its highest since August 2012. It was last at 8.75 percent, still higher than at the end of last year.
"The market is more nervous since the Italian election results with a significant pick up in the front end of the implied volatility curve," Harrison at Marex Spectron said.
Analysts said this week's moves signalled the return of erratic currency moves to the FX markets and that volatility and the cost of hedging against euro weakness elevated.
The euro's outlook is clouded by expectations the ECB may lower growth and inflation forecasts next Thursday. That could pave the way for future interest rate cuts and exacerbate the euro's losses.
This week, investors sold the currency on concerns the euro zone economy remains weak and on worries that uncertainty after last weekend's election in Italy could jeopardise reform and push the country's borrowing costs higher.
This could spill over to Spain despite a conditional pledge from the ECB to buy bonds of struggling euro zone countries, could hurt the euro, at least in the near term.
It hit $1.2966, its lowest in 2013 and it has already lost 1.6 percent this year. Earlier this week one-month risk reversals, which measure the relative demand for options on the euro rising or falling, displayed their highest bias for euro weakness since late June.
"Risk reversals are now in favour of euro puts highlighting both more euro weakness and investors' propensity to pay more for hedging potential risk," said a trader at a large European bank, citing some short-term euro puts at $1.28 with a one-month maturity.
Traders and strategists said option prices could jump because many in the market were still not expecting a dramatic drop in the euro. So a whippy move down could see many investors caught short and trigger a rush to protect themselves against further weakness.
"Since the start of the year, investors are extremely quick to position themselves on the same themes at the same time, putting the liquidity of the option market under temporary strain," said Stephane Bataille, FX options trading strategist at Citi.
"Any move lower in the euro will definitively drive the vols sharply higher not only as nervousness increases but also as demand for downside options intensifies."