Sterling steadies but bets on volatilty hit 3-month high

*  Graphic: sterling and gilt yields http://bit.ly/2dgAXn1

*  Graphic: World FX rates in 2017 http://tmsnrt.rs/2egbfVh

*  Graphic: Trade-weighted sterling since Brexit vote http://tmsnrt.rs/2hwV9Hv (Updates prices, adds graphics)

By Patrick Graham

LONDON, Jan 13 (Reuters) - Bets on swings in the value of sterling over the next week reached their most extreme since mid-October on Friday, as investors braced for a speech by Prime Minister Theresa May on Tuesday that will detail her plans for Brexit.

One-week implied volatility - options contracts that allow traders to bet or hedge against swings in the currency over the next seven days - started climbing on Thursday afternoon as news broke that May was set to deliver a speech.

They rose further on Friday, topping 14 percent - levels not seen since the aftermath of the Oct (Shenzhen: 000069.SZ - news) . 7 "flash crash" in the pound, reflecting the nervousness of the market over May's plans for talks on leaving the European Union.

The pound has been on the defensive all week, driven by an interview with the prime minister last Sunday in which she signalled immigration control would take priority over membership of the EU's lucrative single market - a scenario that has come to be known as a "hard Brexit".

On Friday, Sterling recovered ground lost earlier in the session and at 1640 GMT was trading up 0.3 percent on the day at $1.2203. That left it less than two cents off its lowest levels - bar the October flash crash - in almost 32 years against the dollar, hit on Wednesday.

Against the euro, sterling hit a two-month low of 87.675 pence, before recovering to 87.07 pence - up 0.2 percent on the day but still down well over 1 percent on the week.

"With (Other OTC: WWTH - news) the Brexit overhang not going away right now, any rallies should continue to be well capped on the fear of the possibility for a harder transition (out of the EU)," analysts from currencies exchange LMAX said in a note.

Sterling has fallen almost 20 percent against the dollar since June's Brexit vote and is on course for its fifth week of falls in the last six. Against the euro it has lost 13 percent since June.

"The May speech on Sunday just again confirmed that whatever the plan is the level of uncertainty over a soft or hard brexit is not going to be resolved easily," said Javier Corominas, head of research with currency fund Record (LSE: REC.L - news) in London.

"The more that goes on, the more we expect volatility to pick up and that is negative for sterling. At least for the next couple of months we will be in that mode."

A number of short-term focused traders and brokers said sentiment had turned broadly against the pound, pointing to signs of division among government officials and the possible impact of a political crisis in Northern Ireland on the Brexit process.

"It is trading very heavy," said a senior sales manager with one London-based broker.

"It was notable for me that despite very good data early in the week, the pound struggled, and hard Brexit for me looks like the only kind of Brexit we can have. That wasn't priced in, but is slowly being priced in now." (Additional reporting by Jemima Kelly; editing by Richard Lough)