UPDATE 3-Sterling edges down before parliament's Brexit votes

Sterling edged down on Tuesday as lawmakers prepared to vote on British Prime Minister Theresa May's response to the rejection of her Brexit plan earlier this month. Growing expectations that Britain can avoid a no-deal Brexit have fuelled a 3 percent rally in the pound this month against the dollar and the euro.

But sterling on Tuesday remained below a 3-1/2 month high of $1.3218 and a spike in volatility in derivatives market reflected nervousness about the likely outcome of the votes. The speaker of the British parliament, John Bercow, has chosen seven amendments - including one that would effectively take a no-deal Brexit off the table. Lawmakers will debate and vote on them from 1900 GMT.

Markets are focused on Amendment B, proposed by opposition Labour lawmaker Yvette Cooper, which seeks to shift control of Brexit from May's government to parliament. If successful, this could give lawmakers who want to block, delay or renegotiate Brexit a legal route to do so.

Amendment G by Dominic Grieve, a pro-EU Conservative, which would give lawmakers a chance to propose their own Brexit debates in parliament in February and March, will also be voted on. "I suppose given those amendments have been chosen markets may have discerned that a (Brexit) delay is a step closer," said Neil Mellor, FX strategist at BNY Mellon.

"The prominent amendments that have been chosen are too close to call but if the Cooper and Grieve amendments are carried, that is sterling positive." Cooper's amendment, which could delay Brexit, is considered likely to pass.

At 1800 GMT sterling was down 0.2 percent versus the dollar at $1.3135. It fell 0.2 percent against the euro to 86.98 pence and held well below Friday's 10-month high of around 86.18 pence .

Speaker Bercow's announcement earlier on Tuesday sent sterling to a session high of $1.32. http://tmsnrt.rs/2hwV9Hv

"The risk that we get a disappointment in tonight's vote is clearly there," Unicredit FX strategist Kathrin Goretzki said, though she noted the vote would not significantly dent optimism that parliament had taken control of the Brexit process to avoid a no-deal scenario. "We don’t expect this to be affected in a negative way in tonight's vote. Any correction will be temporary," she said.

Another amendment selected for a vote, proposed by Conservative lawmaker Graham Brady, calls for the Irish backstop arrangement envisioned by May's Brexit divorce deal to be removed and replaced with "alternative arrangements". The backstop is an insurance policy designed to avoid customs checks between EU-member Ireland and British-ruled Northern Ireland after Brexit. Many in May's party oppose it, fearing it could trap Britain in a permanent customs union.

Nervousness was reflected in a rise in implied sterling volatility on options markets, which has fallen steadily since the start of the year. Overnight implied volatility in particular raced to near 23 vol, the highest since Jan. 15, when lawmakers defeated May's Brexit deal. One-month implied vol rose to its highest in a week and a half at 11.2 vol, a day after seeing the biggest one-day rise since November.

(Reporting by Sujata Rao, additional reporting by Virginia Furness; Editing by Janet Lawrence)