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.
- 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.
What Is Capitulation?
Capitulation means 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.
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 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.
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.
Real World 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.
On March 18, 2020, the S&P 500 index was down nearly 10% from the prior day's close amid the COVID-19 market collapse, only to reverse and close down 5.2% on the day and 1.6% below where it opened. That wasn't quite capitulation, however, in retrospect.
On March 23, 2020, the S&P 500 plunged nearly 5% intraday at its lows but managed to close with a loss of "just" 2.9%. We know that was capitulation because the index went on to gain 17% over the next week.