* Nikkei reverses gains to end just above 9,700
* Fails to hold above 9,800 second day in a row
* Steelmakers retreat on Nikko downgrade, profit-taking
By Dominic Lau
TOKYO, March 1 (Reuters) - Japan's Nikkei average fell on Thursday and failed to hold 9,800 for the second day in a row, as domestic investors locked in profits after the index rallied more than 10 percent last month and posted its best February performance in two decades.
The Nikkei closed 0.2 percent lower at 9,707.37 after trading as high as 9,865.75 in the morning session. The index also failed to retain its gains above the key 9,800 on Wednesday.
"Domestic accounts are still selling. They came in late yesterday to sell. They were probably doing the same today," a trader at a U.S. bank said. "The market is in a volatile patch."
The Nikkei suffered its worst intraday volatility in three months on Thursday, with a near 200-point swing from high to low. That compared with an average of 110 points daily swings in February.
Steelmakers were among the underperformers, succumbing to profit-taking after they had gained on recent weakness in the yen as well as on a report by Nikko SMBC, which downgraded the sector to "neutral" from "bullish".
Kobe Steel Ltd, JFE Holdings Inc, Sumitomo Metal Industries and Nippon Steel Corp were down between 3 and 4.3 percent.
Nippon Sheet Glass Co Ltd shed 5.9 percent, down for the third day running, as concerns over its outlook led investors to sharply increase short positions on the stock.
According to securities lending research firm Data Explorers, short selling in Nippon Sheet Glass increased to 8.67 percent of outstanding shares on loan as of Feb. 28 from 6.65 percent on Feb. 24.
The broader Topix index fell 0.5 percent to 831.54.
More than 2.6 billion shares changed hands, down from a seven-month high of 3.06 billion on Wednesday.
LOOKING FOR CATALYST
Takashi Hiroki, chief strategist at Monex Inc, said the liquidity-driven rally seemed to be over for now as there was no fresh catalyst to push equities higher.
"We don't see further ECB additional liquidity operations. (Federal Reserve Chairman) Ben Bernanke's remark yesterday has also removed the expectations of more quantitative easing," he said, adding the U.S. ISM manufacturing data later in the day may provide some direction for the market.
Bernanke stopped short of signalling further Fed bond purchases in his testimony to Congress on Wednesday.
An unexpected jump in fourth-quarter capital expenditure by Japanese companies and a softening yen offered some support to the market, however.
Japanese companies increased their capital spending by 7.6 percent year-on-year in the October-December period, better than the median estimate for a 6.5 percent annual decline, in an encouraging sign of an uptick in demand.
Softbank Corp was up 2 percent and headed the Topix Core 30 list as the biggest percentage gainer after it won coveted spectrum for high-speed mobile services as it races to strengthen its network.
Softbank offered a good risk-to-return ratio as its performance lagged the Topix Core 30 this year, a trader said, but added that a potential issue was how the company would fund any capex.
Another dealer said market participants were still cautious, and many were anxious to sell now in order to bank profits.
"A lot of people were caught flat-footed in this rally and they're questioning their own uncertainty about the direction of the market because it doesn't gel with the bullish market," said the trader, who worked for a foreign brokerage.
Reflecting investors' concerns of a sharp pullback after this year's 14.8 percent rally, the Nikkei volatility index rose 3.6 percent. The higher the volatility index, the lower the appetite for risk.
Technical indicators also fanned such worries, with the 14-day relative strength index at 80.6, deep in "overbought" territory.
But March, the last month of Japan's fiscal year, tends to be strongest month for the Nikkei, with an average monthly rise of 1.43 percent for the index between 1972 and 2011. (Additional reporting by Mari Saito and Miki Kayaoka; Editing by Daniel Magnowski)