Capitulation is a colloquial market term describing a pattern of strong selling, where powerful psychological and market forces have led to market participants liquidating their positions at any price.
Capitulation is usually driven by a combination of fear-induced panic-selling and the forced selling of margin calls.
Identifying Capitulation
While there is no strict measure for what constitutes a capitulation, it generally requires a rare and pronounced period of extreme selling that sees the security drop to lows far beyond those seen in its recent history.
Capitulation involves market participants who either feel that they have no choice but to sell at any price to exit the position or are literally forced to sell at any price to exit their positions. This kind of situation rarely happens in the markets, which is why capitulation events are so noteworthy.
Capitulation and Trading
While capitulation may be rare, it is a very real and significant market event. The extreme selling that occurs during capitulation offers a variety of ways to profit from it if correctly identified.
The foremost method of trading capitulation is short selling. This may be the easiest and safest way, as the signs of capitulation are generally rather clear when they happen, allowing day traders to quickly enter the positions from a relative high point and take quick profits long before the extremes of the bottom are hit.
However, capitulation tends to happen very quickly, with the extreme selling pressure usually occurring in less than one day or as little as a few hours, so day traders need to already be monitoring the security as a likely candidate for capitulation and be prepared to enter the short position as the extreme selling begins.
Another method of trading capitulation is to attempt to call the bottom of the selling. This is obviously a far riskier trade, as it can be very difficult to identify when the bottom of a capitulation has occurred and it opens the day trader up to significant losses if the trade is entered too early.
On the other hand, buying at the bottom of a capitulation tends to offer much greater returns compared to selling into one, as the prices at the very bottom of a capitulation are often extremely low and quickly recover to a much more reasonable territory.
Generally the best method of identifying the bottom of a capitulation is merely time. The psychological and market factors that drive capitulation are inherently fleeting, and once the most skittish and ill-positioned of market participants have sold, cooler heads tend to prevail.
Capitulation and Technical Analysis
Technical analysis can be a very useful tool when attempting to trade a capitulation, as it is mainly a study of psychological patterns in trading, and capitulation is largely a product of psychological factors among market participants.
In particular technical traders tend to look for one or more hammer indicators as a sign that the capitulation has reached its bottom. Hammer indicators are formed when the opening and closing price for the period (the head of the hammer) are set above a long tail price down to an extreme low for the period (the handle of the hammer).
Hammer indicators signal that despite the panic selling that occurs during the trading period, the prices are still closing reasonably close to their open, which shows a slowing and stabilizing downward momentum resisting the ongoing panic selling pressure.
Day traders attempting to identify the bottom of a capitulation are encouraged to use a variety of well-suited technical indicators, with a particular focus on hammer indicators.
Final Thoughts
Capitulations are significant market events that can present day traders with multiple opportunities to make significant profit. However, their inherent unpredictability and instability mean that they also present corresponding risks to day traders who attempt to trade them.
Moreover, once it is clear where in the capitulation process the price is, it is usually too late to profit from it.
Day traders attempting to trade a capitulation can use a variety of technical indicators to help them sort through the rapidly changing price action to identify where in the capitulation process they are. Hammer indicators in particular are very useful for identifying the bottom of a capitulation.