What Is Capitulation?
Capitulation in finance describes the dramatic surge of selling pressure in a declining market or security that marks a mass surrender by investors. The resulting dramatic drop in market prices can mark the end of a decline, since those who didn't sell during a panic are unlikely to do so soon after.
Capitulation typically follows significant downturns in price, which can take place even as many investors remain bullish. As the downturn accelerates, it reaches a point where the selling by the investors unwilling to suffer further losses snowballs, leading to a dramatic plunge in price.
The heavy trading volume accompanying the decline shakes out "weak hands"—the investors lacking conviction—and replaces them with more risk-tolerant holders who may not have suffered prior losses and were willing to buy at the end of a protracted decline capped with a dramatic drop.
Traders look for unusually high trading volume accompanying sharp declines in price to signal capitulation. They try to anticipate the surest sign of a capitulation: the rebound in price that follows once the panic selling has run its course.
Key Takeaways
- Capitulation happens when a significant proportion of investors succumbs to fear and sells over a short period of time, causing the price of a security or a market to drop sharply amid high trading volume.
- Capitulation marks a short-term low in the price and is followed by at least a relief rally.
- Until the price rebounds significantly, there can be no assurance the apparent "capitulation" won't be followed by additional dramatic drops.
- Capitulation causes heavy turnover among investors, enabling a rebound by replacing risk-averse sellers with risk-tolerant buyers, but it can't guarantee those buyers won't eventually sell even lower.
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Understanding Capitulation
Capitulationmeans surrender. In financial markets, capitulation marks the point in time when a large enough proportion of investors simultaneously give up hopes of recouping recent losses, typically as the decline in prices gathers speed.
Suppose a stock you own dropped by 30% but you were sure it would bounce back. Imagine it then fell another 20% but it was clear the fundamentals were solid. Maybe you bought a little more on the dip. Now imagine the same stock is down 15% intraday and the grind of daily disappointment has given way to certain knowledge that you bought a loser that could go even lower. Selling the stock as a result would be an act of capitulation.
Important
Investors can only identify capitulations with certainty after they have occurred and the price has rebounded.
Note that the stock was already down 15% in a day, suggesting others felt the same. While misery may like company, a capitulation requires a panicked crowd.
Capitulation does not mean the sellers were "wrong" or the buyers "right." While a short-term rebound follows capitulation by definition, it doesn't mean prices can't go even lower later, if future reverses turn the new "strong hands" into sellers.
Bear markets can feature repeat high-volume plunges in price and premature calls of capitulation. The truth is that the condition can be diagnosed conclusively only in hindsight if the price rebounds.
Using Technical Analysis to Identify Capitulations
Capitulations often signal major turning points in the price action of underlying securities and financial instruments. Technical analysts use candlestick charts to identify capitulation patterns. One such pattern is the hammer candle, which marks a trading session in which the price drops well below its opening level but reverses to regain much of the loss by the close. When accompanied by heavy volume, it suggests the decline reached a climax.
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Conversely, a shooting star candle describing a session in which price rallies sharply but then reverses to close near opening level often forms at the end of a buying spree, indicating a top is in place.
Example of Capitulation
While capitulations can be hard to tell apart from run-of-the-mill high-volume declines as they happen, they're easy to spot with the benefit of hindsight: just look for a significant rebound in the price.
An interesting example of capitulation occurred with the price of Tesla (TSLA) after reaching its all-time high of $414 on Oct. 31, 2021. Over the next fifteen months, the stock alternated between sharp drops and brief rebounds. By the opening of 2023, TSLA had reached a low of $101, a loss of more than three quarters.
However, the stock rebounded just as quickly, reaching $208 over the next six weeks, with daily volume at one point exceeding $1 billion. In retrospect, the final price drop represented a period of capitulation, as speculators accepted their losses and new investors assumed their positions.
How Do Traders Identify Capitulation?
Traders and analysts may observe a variety of sentiment and technical indicators, such as the relative strength index, fibonacci ratios, candlestick patterns, and the moving average convergence-divergence, to determine when the buy or sell pressure for a certain asset is close to exhaustion. However, none of these methods is faultless, and the only 100% accurate way to identify capitulation is in hindsight.
How Long Does Capitulation Last?
There's no set criteria for the length of a capitulation period, and some markets may take longer to recover than others. For example, the Great Recession of 2008 lasted 18 months, but it took several years for the economy to recover completely.
Is Capitulation Good or Bad?
Capitulation is neither good nor bad, but it can be profitable depending on an investor's position. Investors with a long position stand to profit during a bullish capitulation as short sellers close out their positions. During a bearish capitulation, speculators may have the chance to snatch up shares at a discount as other traders abandon their positions.
The Bottom Line
Capitulation is a period of prolonged price drops that causes investors to sell their positions and accept realize losses, rather than see their assets dwindle further. This may occur as the final stage of a bubble, when inflated asset prices collapse. However, after capitulation, the asset may begin to appreciate again.
