What is Capitulation?

What Is Capitulation?

Capitulation is when investors give up any previous gains in any security or market by selling their positions during periods of declines. Capitulation can happen at any time, but typically happens during high volume trading and extended declines for securities. A market correction or bear market often leads investors to capitulate or panic sell. The term is a derived from a military term which refers to surrender.

After capitulation selling, many traders think there are bargain buying opportunities. The belief is that everyone who wants to sell a stock for any reason, including forced selling due to margin calls, has already sold. The price should then, theoretically, reverse or bounce off the lows. In other words, some investors believe that capitulation is the sign of a bottom.

While traders often attempt to anticipate capitulation selling or buying, the reality is that capitulations are after-the-fact outcomes that result from the maximum psychological and financial pain that can be endured by investors before liquidating their positions.

Important

Investors can only identify capitulations after they have occurred

Understanding Capitulation

By definition, capitulation means to surrender or give up. In financial circles, this term is used to indicate the point in time when investors have decided to give up on trying to recapture lost gains as a result of falling stock prices. Suppose a stock you own has dropped by 10%. There are two options that can be taken: you can wait it out and hope the stock begins to appreciate, or you can realize the loss by selling the stock. If the majority of investors decides to wait it out, then stock price will likely remain relatively stable. However, if the majority of investors decides to capitulate and give up on the stock, then there will be a sharp decline in its price. When this occurrence is significant across the entire market, it is known as market capitulation.

The significance of capitulation lies in its implications. Many market professionals consider it to be a sign of a bottom in prices and consequently a good time to buy stocks. This is because basic economic factors dictate that large sell volumes will drive prices down, while large buy volumes will drive prices up. Since almost everyone who wanted (or felt forced) to sell stock has already done so, only buyers are left - and they are expected to drive the prices up. (To learn more, see: Profiting From Panic Selling.)

The problem with capitulation is that it is very difficult to forecast and identify. There is no magical price at which capitulation takes place. Often, investors will only agree in hindsight as to when the market actually capitulated.

Using Technical Analysis to Identify Capitulations

Capitulations often signal major turning points in the price action of underlying securities and financial instruments. Technical analysts can visually identify capitulation using candlestick charts. Hammer candles often form at the end of a selling frenzy when the lowest price is made, as capitulation sets in and signals a price bottom followed by a reversal bounce on heavy volume. Traders who wanted to sell their positions have done so as panic reached a climax. As fear starts to subside, greed may set in and reverse prices.

Image by Julie Bang © Investopedia 2020

Conversely, a shooting star candle often forms at the end of a buying frenzy, when prices reach their high, indicating a top is in place. Traders who wanted to buy a position have done so, and the fear of missing out has reached an extreme. The greed of attaining a position at any cost starts to subside when prices fall rapidly. When the last group of buyers sees their positions declining, fear starts to creep into the market. As prices continue to fall, buyers who purchased earlier start to sell their positions to salvage remaining profits or limit losses.

The extent of capitulation can be measured on different charting time frames as small as a one-minute chart, or as large as a monthly chart. Larger time frames typically produce more reliable capitulation signals as they allow participants to engage and determine the outcome of price action.