A common term amongst traders is capitulation. This term has meaning outside of the trading world, which is basically giving up or surrendering completely. Applied to trading, this is a common observation during a period of selling, both in long and in short moves. Simply defined, capitulation occurs when a significant amount of long positions are abandoned, creating a sharp period of selling and price decline. Capitulation is actually a very intuitive concept, especially when one considers the emotional aspects of capital market trading. Periods of capitulation also offer one of the most excellent inefficiencies in the market which can be exploited by savvy traders.
Capitulation can mean two ways to make money to a trader who successfully can identify the moments it is taking place. The shortest term traders understand that taking a short during this period of time is about as close as trading gets to “free money”. The selling is often so rapid and so fast, that a trader only needs the courage to take a position short, and often the position will quickly be in the money, and remain in the money until the end of the selling. These traders must understand the moment the selling is over though, because to longer term traders this moment signals an excellent opportunity to buy at an “inefficiently cheap” price. Capitulation most often marks the bottom, or very close to the bottom of a decline in price.
Here is an excellent example of capitulation in GE. Capitulation occurred on March 4th of 2009.
True capitulation is marked by an extreme increase in volume as sellers are scrambling to exit positions, and not enough buyers are present to control the pace of selling. Notice the massive spike in selling volume on March 4th, 2009. Notice as well how this marked the exact bottom of the decline in price. From this point GE went on to more than double in price in only 2 months! This is obviously not a “day trade” but imagine how much money was made by some traders who identified this final push down as the capitulation point. The volume uptick coupled with the sharp decline provided a very clear signal that many long positions were selling out.
As more sellers paniced out of their positions, it created more downward pressure on price. This had the effect of both forcing other long positions to realize their loss before it got even bigger, and making potential buyers step out of the way as the downward pressure was so hard. The lack of buying meant sellers had an even greater effect on price than they would have during other periods.
At some point the panic selling stops, and buyers realize that the price has moved far from its rational value. Timed correctly, buyers often have large gains when rational behavior returns and prices move back to more efficient levels.
While this is an example on a very large scale, capitulation can be seen intra-day at points when many traders and trading algorithms are forced out of their positions at the same time by a large seller, and the price falls quickly accompanied by sharp volume to inefficient levels. For those who identify the move as capitulation it can provide excellent trading opportunities.