* Euro in downtrend but drop likely to be gradual -trader
* Mounting risk aversion supports dollar
* Aussie trims loss after dipping below parity vs USD
* Worries grow as European bank funding condition tightens (Updates levels, adds comments)
SINGAPORE, Nov 18 (Reuters) - The euro edged higher on Friday as traders covered short positions and booked profits after its recent drop to a five-week low, and the single currency was expected to remain on a downtrend because of the spiralling euro zone debt crisis.
The spotlight fell on Spain on Thursday, which had to pay the highest rate to sell its 10-year debt since 1997, just shy of the 7 percent mark seen as unsustainable.
The euro, however, showed some resilience in the wake of the Spanish bond auction, managing to hold above a five-week trough of $1.3421 hit in Thursday's Asian trade.
The euro is being supported by short covering, said Jesper Bargmann, Asia head of G11 spot FX for RBS (LSE: RBS.L - news) in Singapore, adding that such profit-taking interest is likely to persist and limit the speed of the euro's declines.
"Market is very eager to sell the euro and also eager to take some profits," Bargmann said. "So we are seeing interest on the dips to buy."
"There's plenty of two-way interest in the euro now," he added. "There's a lot of short positions out there and people are eager to book some profit. So it's not an easy trade."
The euro rose 0.2 percent to $1.3484, but is still down roughly 2.4 percent for the week, on track for its biggest weekly percentage decline since early September.
Selling pressure against the single currency has intensified this week as turmoil in euro zone bond markets spread to AAA-rated France.
The euro is likely to test its early October low of $1.3145 eventually, but its descent will probably be gradual, said Bargmann.
"I think we'll break $1.30 but I think it's going to be in a fairly orderly fashion," he said, adding that there were likely to be some spikes and bouts of short-covering in between.
Support for the euro lies at around $1.3405, the 76.4 percent retracement of the October rally. The bottom of the weekly Ichimoku cloud also offers support near that level, coming in at $1.3408.
A trader for a Japanese brokerage in Tokyo said there was talk that a euro option position with a strike at $1.35 was set to expire today, and that players holding such a position may buy the euro on dips and sell into rallies.
"The direction is probably toward the downside but looking at how the market has been moving and positioning, you have to be wary of short-covering," the trader said.
DOLLAR FUNDINS STRAINS
The deepening of the euro zone's debt crisis has caused heightened stress in dollar funding markets this week.
The premium for swapping euros into dollars rose on Thursday, with the three-month cross-currency basis swap around 6 basis points wider at -136 basis points, the most since the 2008 financial crisis.
"The slow motion train crash continues, with USD funding now clearly a bigger issue as contagion spreads more deeply into Spain," said Sebastien Galy, strategist at Societe Generale (Paris: FR0000130809 - news) .
The Australian dollar, which tends to come under pressure in times of market stress, dipped to as low as $0.9973 earlier, matching a five-week low touched on Thursday.
The Aussie later pared some losses to change hands at $1.0002, down 0.1 percent from late U.S. trade on Thursday.
"While risks to the downside appear more apparent, it's worth noting that the currency is now oversold on several momentum-based indicators," said David Scutt, a trader at Arab Bank Australia in Sydney.
"Keeping this in mind, should any good news surrounding Europe (Chicago Options: ^REURUSD - news) hit the screens, it's likely to see the Aussie spring higher on the back of short covering."
Against the yen, the dollar dipped 0.1 percent to 76.87 yen , with investors wary of further Japanese action in the wake of its massive intervention on Oct (KOSDAQ: 039200.KQ - news) . 31. (Additional reporting by Ian Chua in Sydney, Hideyuki Sano in Tokyo; Editing by Kavita Chandran)
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