I'd install the highest your undisclosed version of Windows will allow. The 3D stuff everyone thinks about won't matter much for CT65K, it's the other APIs no one thinks about (like DirectInput). I've had a similar computer for 200x source ports and emulators that linked to dinput8.

What version of DX a game uses and what version of DX you have installed are different things. It can be also said something similar with the driver/hardware -- you can go as high as you want with DX support, and be limited by your chip/driver when it comes to hardware supported acceleration. Your graphics chip & windows driver probably does have some kind of DirectDraw support, as evidenced by your test. You might be able to confirm more with dxdiag. But DirectDraw goes all the way up to DX 7, so you might as well run at least that, so you can try a DX 7 game if you want.

Every DX program, if you don't have hardware support for a feature, can fall back on a software rendering path. You might be able to run early Direct3D games, slowly, and run any Direct3D demo or game in full software too. So you can install any DX as high as you can go. The game won't use higher than it was programmed for.

The lack of framebuffer memory will pose some limitation to DirectDraw games, regardless of DX version. So you are looking at DirectDraw games, or really really simple early Direct3D game support on your PC, with any DX you chose to install. So what you will need will just depend on the game and if you meet the game's requirements.

As you're running Win98SE it should come with DX6.1 already.. Installing DX3 and 5 won't change that - there is only up.

What would benefit performance would be a newer video driver that supports linear writes on the CT65K because oddly it doesn't support that for the Win9x drivers, yet the chipset can do it (on Windows 2000 at least).

No real need to go greater then the most demanding game
e.g. Diablo required DX3, Win98 has 6.1, therefore your already covered.
Honestly I doubt you'll need much more then 6.1 on a P120

The latest that Win98 will support is DirectX 9.0c - don't try the commonly-available web version but instead download the full version.

Looking at my win98 machines, 3 have 6.1a, while 1 has 9.0b .

I would say the highest version your games require.