Just before election, Nikkei goes on wild ride

Kiyoshi Ota | Bloomberg | Getty Images

The Nikkei went on wild ride on Friday, falling sharply from a two-month peak as volatility returned to Japan's benchmark stock index just before the key upper house of parliament election on Sunday.

Japan's stock market was down 1.6 percent at around 14,562 in mid-day Asian trade, having traded with a gain of more than 1 percent and a fall of as much as 2.7 percent.

Traders attributed the sudden bout of volatility, reminiscent of the swings that hit the Nikkei in late May, to profit-taking ahead of Sunday's election that sparked large scale selling of stock futures.

(Read More: What Sunday's Japan election means for Abenomics)

"The move down took a lot of people by surprise, but what we've been worried about all week is the level of optimism in the market is way too high," said Ben Collett, head of Asian equities at Sunrise Brokers in Hong Kong, talking on CNBC Asia's "Cash Flow" about the sudden Nikkei sell-off.

The Nikkei has rallied roughly 18 percent from a low hit in June, with recent gains boosted by weakness in the yen and expectations for a big win for Prime Minister Shinzo Abe's ruling coalition in Sunday's upper house elections that could pave the way for highly-anticipated economic reforms.

"The sell-off in the Nikkei was all futures led," said Chris Weston, chief market strategist at trading firm IG. "Of course the election is in focus, but that should be a positive."

(Read More: Is the Nikkei getting its mojo back?)

Opinion polls point to a clear majority for Abe's Liberal Democratic Party (LDP) and its coalition partner, the New Komeito party in the upper house election that would end years of parliamentary stalemate.

Why to be bearish

Collett at Sunrise Brokers said he was bearish on the short-term outlook for Japanese stocks, adding that the Nikkei could fall at least another 10 percent from current levels.

"Let's assume Abe wins a massive majority. What else have you got for markets in August? Not a whole lot. Even if he wins, he's not going to do anything until August so what you then do is say 'ok we've got an uncertainty, the market is net-long' so this is a forward thinking move to say 'I've made my money this month so I'm out of here,'" Collett said.

(Read More: Japan's quarterly commercial real estate sales soar 78%)

Takuji Okubo, principal and chief economist at Japan Macro Advisors in Tokyo, told CNBC he shared the caution on the Nikkei.

"I am relatively cautious on the stock market front," he said. "After the election, let's look at how Abe tackles reforms. For instance will he go ahead with a consumption tax hike? If he does that could be negative for stocks."

Abe's ruling coalition controls the lower house of parliament and a majority in both houses is expected to pave the way for the long-term economic reforms or the "third arrow" of Abe's three-arrow economic strategy.

The other two arrows include monetary stimulus and fiscal spending and have been already delivered this year.

"I am positive on the market long-term. Polls have shown that the LDP will win a big enough majority in the elections to implement "Abenomics," said Daphne Roth, head of equity research at ABN Amro.

(Read More: Fate of yen hinges on weekend elections)

"I don't think it's just the elections that are going to boost the market. There's also the yen, which we expect to weaken to 110 against the dollar this year and to 120 next year, which will be very positive for profit margins and underpin the performance of Japanese equities," she added.

The yen hovered around 100 per dollar on Friday. It has weakened about 16 percent this year.

— By CNBC's Dhara Ranasinghe; Follow her on Twitter: @DharaCNBC