(Corrects paragraph 7 to ... softer yen ... instead of ... softer dollar)
* Nikkei 0.3 pct lower as market overheated after rally
* Softer yen supports underlying sentiment
TOKYO, Dec 16 (Reuters) - Japan's Nikkei average edged lower on Thursday as optimism over the dollar's rise to a near three-month high against the yen the previous day was offset by worries over euro zone debt and overheating in the market.
The Nikkei has been trapped in a narrow 190 point range for over a week as domestic investors aggressively took profits on its rally of around 12 percent since the beginning of November, while foreign investors continued buying financial shares seen as undervalued.
Japanese shares, which are down some 2.2 percent in the year to date and have underperformed globally, fell on Wednesday when investors' appetite for risky assets lessened as worries about euro zone bonds resurfaced after Moody's warned it may downgrade Spain's debt.
"The Nikkei is taking a breather after a six-week rally, but sentiment remains bullish overall," said Takashi Ohba, a senior strategist at Okasan Securities.
Ohba said that while major global cyclical stocks, which are seen as overbought, are edging lower, retail investors continue picking up low-priced smaller stocks, boosting volume and adding to the underlying positive mood.
"If the dollar gains a little bit more against the yen and goes above 85 yen it could trigger the Nikkei's move above the current tight range," said Ohba.
A softer yen supports exporters in the long run, as many of them based their earnings estimates for the October-March second half on an assumed dollar/yen rate of around 80-83 yen.
In the options market on Wednesday traders cited strong buying of dollar calls -- a bet of further currency appreciation -- against the yen, sterling and the euro.
Aozora Bank Ltd surged 7.8 percent after Goldman Sachs started coverage of the bank at "buy" and a target price of 190 yen. The brokerage said the stock is cheap, with its price-to-book ratio around 0.52 for the financial year ending next March compared with the banking sector's average PBR of 0.73.
Kobe Steel Ltd outperformed the broader market, gaining 0.5 percent after India's Essar Steel said on Wednesday the two firms would set up a plant to manufacture high strength steel sheets for the automotive sector. (Additional reporting by Ayai Tomisawa; Editing by Michael Watson)