What Is Capitulation?
Capitulation in finance describes the dramatic surge of selling pressure in a declining market or security, marking a mass surrender by investors. This often leads to a significant drop in market prices and can signify the end of a decline, as those who didn’t sell during the panic are less likely to do so afterward.
Capitulation typically follows significant downturns in prices, which can occur even when many investors remain optimistic. As the downturn accelerates, it reaches a point where selling snowballs, resulting in a dramatic price plunge.
Heavy trading volume usually accompanies these declines, replacing ‘weak hands’—investors lacking conviction—with more risk-tolerant holders who buy at the end of a protracted decline capped by a dramatic drop.
Key Takeaways
- Capitulation takes place when a significant proportion of investors give in to fear and sell in a short period, causing sharp drops in prices amid high trading volume.
- Short-Term Low: Capitulation marks a low in price that is followed by at least a relief rally.
- Uncertainty: Until significant price rebounds occur, further dramatic drops cannot be ruled out.
- Investor Turnover: Capitulation causes high turnover, typically leading to a rebound as risk-averse sellers are replaced by risk-tolerant buyers.
Understanding Capitulation
Capitulation means surrender. In financial markets, it signifies the moment when a substantial number of investors give up on recouping recent losses as prices continue to decline.
Consider a scenario: a stock you’re holding drops by 30%, yet you’re confident it will bounce back. If it then falls another 20%, but its fundamentals remain strong, you might buy more on the dip. Until, one day, it suffers an additional 15% intraday drop, transforming daily disappointment into a certainty that you bought a loser. Selling in such a moment would be an act of capitulation.
Important
Capitulations can only be confirmed with certainty after they have occurred and the price has rebounded.
Bear markets may include repetitive high-volume price plunges and premature capitulation calls. Only in hindsight, when prices rebound, can capitulation be conclusively identified.
Using Technical Analysis to Identify Capitulations
Technical analysts utilize tools like candlestick charts to spot capitulation patterns. One effective pattern is the hammer candle, indicating a session where prices drop sharply but regain much of the loss by closing time. High trading volume in such a session indicates a climax in the decline.
Conversely, the shooting star candle can denote a session ending a buying spree, symbolizing a market top.
Example of Capitulation
Capitulations are easier to identify in retrospect than while they are happening. A notable example is Tesla (TSLA). After hitting a high of $414 on Oct 31, 2021, TSLA went through fluctuating drops and brief rebounds over fifteen months. By early 2023, it had dropped to $101, reflecting over three-quarters fall. Shortly after, the stock rebounded to $208 in six weeks, showcasing typical capitulation behavior.
How Do Traders Identify Capitulation?
Traders rely on sentiment and technical indicators, including the relative strength index (RSI), fibonacci ratios, candlestick patterns, and the moving average convergence-divergence (MACD) to gauge buy or sell pressure exhaustion. However, these methods are not foolproof, with capitulation often being evident only in hindsight.
How Long Does Capitulation Last?
There are no specific criteria for the duration of capitulation periods. Market and recovery spans vary. For instance, the Great Recession of 2008 spanned 18 months, but complete recovery took several years.
Is Capitulation Good or Bad?
Capitulation is neutral. Its effects depend on the investor’s stance. Long position investors may profit if a bullish capitulation sees short sellers closing positions. On the other hand, during bearish capitulation, opportunists might buy discounted shares as markets react to ongoing drops.
The Bottom Line
Capitulation involves prolonged price drops leading investors to sell their holdings and accept losses to prevent further depreciation. Post-capitulation, assets might appreciate, often ending a bubble where previous overvalued prices return to realistic levels.
References
- Yahoo Finance. “Tesla, Inc (TSLA)”.
