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FX traders heed Draghi "don't short" advice on euro
* ECB's resolve to protect euro helps sentiment
* Euro seen firmer before next ECB meeting
* FX Options indicate euro losses versus dollar to slow
By Anirban Nag
LONDON, Aug 7 (Reuters) - European Central Bank chief Mario Draghi's warning not to bet against the euro has given traders pause and should see the currency rise in coming weeks though any delay in implementing anti-crisis measures will see it punished.
Since Draghi's comments last Thursday, which highlighted his determination to save the currency bloc from disintegration, the euro has risen to a one-month high against the dollar and the British pound.
It has also bounced against other currencies on expectations the ECB will take decisive action to lower crippling borrowing costs for Spain and Italy, the two countries at the epicentre of the three-year-old euro zone debt crisis, which could still tear the bloc apart.
Draghi's words have reduced the risk of a nasty euro-negative surprise, traders and analysts said. But, they add, they have only won policymakers limited time to turn their pledges into action.
Last week, the ECB indicated any resumption of its bond-buying programme would not come before September and that such a move would happen only if governments applied for assistance from the euro zone's rescue funds.
Nonetheless, traders, who had persistently sold the euro this year, welcomed Draghi's willingness to put in place policies to prevent a break-up of the currency and said his comments had raised the risk of betting against its survival.
"It's pointless to bet against the ECB. The risk-reward for euro short positions has shifted," said a senior foreign exchange trader at a large bank, referring to bets the eruro will fall.
"Draghi has opened the door for aggressive ECB action should peripheral spreads widen further. Once Spain and Italy relent and seek European Union aid, we believe markets will rally."
While details of how the ECB will buy bonds and how much it is prepared to spend are still sketchy, its willingness to take bold decisions should help the euro recover some of the year's lost ground before the central bank's September meeting.
"A new intervention tool is in the making which creates unlimited firepower to defend European sovereigns..." said George Saravelos, currency strategist at Deutsche Bank.
"The fact that this backstop is now being created will serve to substantially reduce risk premia on European assets as well as the euro, even before the details are worked out. It's now time to turn tactically bullish euro against the dollar, the yen and sterling."
The risk premium is the extra amount investors seek while buying an asset over a risk-free counterpart.
Saravelos saw the euro firming to $1.27, 100 Japanese yen and 81 pence against sterling. The euro was trading at $1.2425, 97.50 yen and 79.35 pence on Tuesday.
In the options market, demand to hedge against further short-term euro weakness is ebbing while one-month risk reversals, which measure the relative demand for put or call options in a currency, are showing a reduced bias towards more euro falls.
"The ECB's decision to limit sovereign spreads reduces the probability of a serious euro accident like Spain losing market access," said Paul Meggyesi, currency strategist at JPMorgan.
Spanish Prime Minister Mariano Rajoy suggested last week he was inching closer to requesting help from the euro zone rescue fund, although he wanted to see the conditions that would be attached.
Traders said they are willing to give Draghi until September to work out the details. In the meantime, the euro could pare some of its losses, although a sustained rally into the year end is unlikely.
"As a result (of Spain seeking aid) the euro could squeeze higher above its current $1.20-$1.25 range against the dollar this month," said Mansoor Mohiuddin, head of FX strategy at UBS.
"But we maintain our longer-term $1.15 target as ECB balance sheet expansion will cyclically weaken the currency again."
The fact the ECB is willing to expand its balance sheet well beyond its current 3 trillion euros, making it even bigger than that of the U.S. Federal Reserve, is a green light to sell the euro more aggressively, some analysts say.
"We expect the euro to weaken to $1.15 by year-end. Weak periphery fundamentals...combined with our call for an ECB rate cut in September should weaken the euro, particularly if QE3 in the U.S. only follows further negative data," Bank of America-Merrill Lynch strategists said in a note.
Another round of quantitative easing (QE3) in the United States is expected to weigh on the dollar and give other currencies, including the euro, a boost.
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