We, traders, are all aware that panic trading can significantly damage a market condition. However, there are certain situations where panic selling happens. One such condition is called ‘capitulation’. In finance, capitulation is a condition referring to panic selling by traders. It builds momentum and causes a dramatic decline in company stock prices. Experts describe it as a situation, where investors willingly give up all gains to exit the market. They may liquidate all or most of their holdings in the situation.
Let’s try to understand what capitulation is with the help of an example. Suppose the stocks you own declined by 10 percent. When it happens, you can either wait it out or sell your holding to realise your loss. If the majority of the investors decide to sell and exit the market, it can cause a dramatic fall in stock price.
What Causes Capitulation?
Capitulation can happen in any market condition but often occurs after a period of a continuous downtrend. It is accompanied by trading in high volume with a price decline, causing the stock price to hit the floor.
However, once the market hits bottom, it is followed by a sustainable and robust rally. So, when a situation like panic selling happens, market experts analyze if there is enough fear factor in the market to pull it to the bottom. Some of the factors that indicate the presence of fear factors in the market are – high trading volume, high ratio of options trading, and extreme volatility. When all these factors are active in the market, then it is a condition of capitulation.
Most experts believe after capitulation occurs, it presents investors with a bargain buying opportunity. It often occurs at the climax of a long, downward slide. Let’s discuss the signs of capitulations in detail.
Massive Change In Trading Activities
Capitulation impacts volume. It involves trading in unusually large volume along with price decline for a day or two, though the situation can last longer.
Cash Withdrawal By The Mutual Funds
If there is a general decline in investors’ sentiment, then mutual funds are forced to reserve large cash volume to honour its clients when they try to exit the market by selling their mutual funds.
High Ratio Of Derivative Trading
When several traders are trying to participate in derivative trading, purchasing put options, it indicates that traders are betting against a market rise or furiously trying to hedge against a further price decline.
Profound Negative Sentiment of Investors
According to the definition of: ‘what is capitulation?’ several books refer to it as a condition resulting from a profound negative sentiment of investors. There is a general sense of ‘giving up’ that isn’t caused by any external force or market condition. It is mainly due to a change in the fundamental outlook of a company. Investors can develop a pessimistic view from the news in media, analyst reports, or from the reaction of fellow traders.
The issue with capitulation is that it can’t be predicted and so analyst can’t forewarn the market before it happens. Still, traders use several technical trading charts to identify a turning point in an underlying asset price like candlestick charts. Candlestick charts help traders visualise any abrupt change in price. Also, they compare price movements in different timeframes to study the extent of capitulation.
Conclusion: Why Does Capitulation Matter?
It isn’t easy to spot a capitulation before it happens. However, since capitulation signals that the market has hit the floor, it is followed by the market turnaround. Excessive selling will pull the price down, creating opportunities for bull traders to buy low. This eventually will drive the market up again.