FOREX-Yen rises ahead of BOJ decision

* Dollar/yen retreats after hitting high of 90.25 yen

* Investors position for aggressive action from BOJ

* Risk of disappointment could lead to yen gains

LONDON, Jan 21 (Reuters) - The yen rose against the dollar on Monday from a 2-1/2 year low, with traders trimming large bets against the currency in case measures expected from the Bank of Japan are disappointing. The yen is likely to stay firm until the BOJ's policy decision is known after the two-day meeting ends on Tuesday. The central bank, which is expected to double its inflation target and increase its asset purchase programme, said it would begin the meeting earlier than usual. Traders and analysts said if the BOJ met expectations then the dollar would lose a bit more ground, given the huge gains it has made since October and investors such as hedge funds would be keen to book profits. Short yen positions were significantly large before the BOJ meeting. Financial markets are expecting a joint statement from the bank and the government to announce a 2 percent inflation target, an increase in asset purchases with an open-ended commitment, and possibly other measures, traders said.

The dollar was down 0.6 percent on the day against the yen at 89.45 yen. It had earlier touched 90.25 yen during Asian trading hours, its highest level since June 2010, only to retreat as traders trimmed bets on further yen weakness given the BOJ has often fallen short of market expectations. "We see a bit of short covering going into the BOJ meeting with people being a little mindful that there could be some disappointment," Jeremy Stretch head of currency strategy at CIBC World Markets. "Investors are being mindful that the moves we have seen over the course of the last month or two are just worth locking in at least until we understand how the BOJ are really going to play in the future." Chartists cited support for the dollar near 89.10 yen, the low hit on Jan. 14, and said if it stayed above that investors would still see it as a good opportunity to buy dollars on dips.

Since mid-November, the dollar has risen about 13 percent on the yen while the euro has risen about 20 percent against the Japanese currency. "It is reasonable that some of the investors are closing record short yen positions ahead of the meeting," said Carl Hammer, chief currency strategist at SEB Merchant Banking. He said that while the dollar would be headed higher against the yen this year, there was room for correction in the near term, leaving the dollar to trade between 86-88 yen in the one-month horizon. Against the yen, the euro fell 0.6 percent to 119.11 yen , off a 20-month peak of 120.73 hit last week, while the Australian dollar shed 0.5 percent to 94.19 yen, slipping from a four-year high of 95.02 set Friday.

NEAR TERM OPTIONS JUMP Some of the nervousness in the currency market before the BOJ decision was reflected in the options market where overnight implied volatilities in dollar/yen jumped to 28 percent from around 15.3 percent late last week. Traders said there was strong demand for options betting on further yen weakness, with one-month dollar/yen implied volatility - a measure of expected price movement - at 11.5 percent, not far from a 17-month high struck on Friday. Meanwhile, the euro was flat on the day at $1.3310, having been capped by the $1.3400 level in the past week with traders citing stop-loss sell orders under $1.3280 and $1.3250. Strategists said the euro was likely to remain firm over the next few sessions as concerns around the euro zone crisis continued to ease, unless sentiment data later this week surprised to the downside. The Bundesbank said on Monday that Germany's economic slump should be short-lived, adding that euro zone's largest economy could have already bottomed out. Data on Friday showed currency speculators increased their bets against the U.S. dollar and went long on the euro, helped prospects in the euro zone were starting to improve. Speculators trimmed their bets against the yen in the week to Jan. 15, although they remained overwhelmingly negative on the currency.