By Saikat Chatterjee and Elizabeth Howcroft
LONDON (Reuters) - The British pound stepped back from a near nine-month high on Thursday as investors booked profits from a recent rally in case of a surprise UK election outcome later in the day.
Voters were heading to the polls in an election that will pave the way for Brexit under Prime Minister Boris Johnson or propel Britain towards another referendum that could ultimately reverse the decision to leave the European Union.
Investors in the cash market have bet on a Conservative Party majority, bolstering the pound in recent days. Market watchers expect such an outcome to lift Brexit uncertainty 3-1/2 years after Britain voted to leave the European Union.
While investors have largely been focussing on the short-term dynamics of the election, it is the final Brexit outcome and progress in subsequent trade negotiations which will determine the outlook for the pound over the medium term.
"The immediate price action in sterling will obviously be driven by the election outcome, but the magnitude of the majority will also be important," said Ugo Lancioni, head of global currency at Neuberger Berman.
In late London trading on Thursday <GBP=D3>, the pound was 0.6% lower at $1.3122 against the dollar and weakened around 0.5% to 84.74 pence versus the euro <EURGBP=D3>. It hit a high of $1.3229 in early Asian trading, its highest since late March.
"Turnover is low given the uncertainty going into the election," said Adam Cole, chief currency strategist at RBC Capital Markets, who attributed the day's move to market thinness amplifying the impact of transactions.
"Those that can will be holding off and I certainly think that's the best strategy - just to stay on the sidelines until we get the news tonights," Cole said.
The exit poll at 2200 GMT will be the first indication of the result.
Graphic - Pound risk reversals: https://fingfx.thomsonreuters.com/gfx/mkt/12/9880/9792/c.png
Overnight implied volatility gauges <GBPONO=FN> jumped to 45%, their highest since around the Brexit referendum vote in June 2016 as investors braced for a rocky night.
The premium for pound put options over call options <GBPSWRR=> over the next week jumped to its highest since September 2016 at nearly 6% as investors sought to protect themselves from any fall in the value of the pound by buying derivative contracts.
DTCC reporting data shows some 8 billion pounds worth of options expiring in December and January with strike prices at $1.3500, but not much above.
Traders note plenty of exotic option barriers placed at 1.3500 too, which suggests that even a positive election outcome, investors don't see sterling going much above that level in that period.
(A strike is the price at which an option can be exercised, while barriers are levels generally defended as holders receive a payout if they remain untouched through expiry.)
(Reporting by Saikat Chatterjee; Additional reporting by Elizabeth Howcroft and Richard Pace; Editing by Larry King, Kirsten Donovan)