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Capitulation

Liquidating an existing long stock position amid an extended decline in stock prices

What is Capitulation?

Capitulation refers to a situation in which investors/traders liquidate their existing long stock position during an extended stock price decline. It can be viewed as the moment in which investors/traders lose hope in their long position and accept losses.

 

Summary

  • Capitulation is the moment in which investors/traders lose hope in their long position and liquidate at a loss.
  • When investors/traders capitulate, they sell for fear of a continual decline in the stock price.
  • The end of a capitulation can present a buying opportunity due to the opinion that everyone who wanted to sell has already done so.

 

Understanding Capitulation

Capitulation, derived from the military, means to give up or surrender. Extending the term to the financial world, it is used to describe a situation in which investors/traders give up on their long positions, which are at an existing loss, and sell for fear of a continual decline in the stock price. Capitulation is the final stage of panic selling, where people will sell at any price to alleviate the pain from seemingly endless selling pressure.

For example, assume a trader owns a high-conviction stock that has dropped 15% from his/her initial purchase price. The trader has two options: (1) wait out and hope the stock price appreciates, or (2)  sell and realize a loss. If the trader decides to sell the stock, which is already at a 15% loss, the trader would have effectively “capitulated” on his/her position.

Capitulation can occur at an individual level, described in the example above, or at a market level, termed “market capitulation.” Market capitulation refers to a situation in which a majority of investors/traders liquidate their positions, causing panic selling across the market. Examples of such events include:

  • The 40% drawdown of the global cryptocurrency market in May 2021 in reaction to negative headlines coming out of China
  • The 30% drawdown of the S&P 500 Index from the months of February 2020 to March 2020 in reaction to the emergence of the coronavirus

 

What Causes Capitulation?

Capitulation typically occurs during a period of continual stock price downtrend, which can be caused by fear, uncertainty, and doubt (“FUD”), such as:

  • A bear market
  • Poor earnings results
  • Negative company or market headlines

 

Capitulation in a stock can often be identified by heavy selling volume and a sharp drop in price following an extended period of a stock price decline. An example is provided below:

 

Capitulation
Source: Bloomberg

 

The chart above shows the capitulation of investors/traders in Alibaba Group Holdings Limited. Following a multi-month stock price decline, capitulation likely occurred in November 2021, resulting in the stock price of Alibaba dropping from $167 to a low of $109, a decline of 35% within two weeks.

 

The Cycle of Investor Emotions

The following shows a chart that describes a typical market cycle:

 

Capitulation - Cycle of Investor Emotions
Source: Barclays (from Model Investing)

 

As illustrated above, capitulation tends to take place near the end of a market cycle where investors reach a point where they say “enough is enough,” and exit the market at a loss. However, as the chart points out, and as will be discussed further below, the end of a capitulation tends to point to an attractive buying opportunity.

 

Trading on Capitulation

The end of a capitulation can result in bargain buying opportunities. This is due to the opinion that everyone who wanted to sell has already done so. The end of a capitulation is difficult to identify, and traders generally rely on oversold signals from technical indicators or candlestick pattern formations to identify the pattern.

An example of a technical indicator and a candlestick pattern used by traders to identify the end of a capitulation period is the relative strength index (RSI) and a hammer candlestick, respectively.

 

Additional Resources

Thank you for reading CFI’s guide to Capitulation. To continue your development as a world-class financial analyst, these additional resources will be helpful:

  • Cryptocurrency
  • Hammer Candlestick
  • Technical Indicator
  • Investing: A Beginner’s Guide

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