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July 30 2010 | Filed Under Active Trading , Bear Market , Financial Crisis ,
Stocks
Investors and traders face many obstacles in their quest for profits.
Throughout even the longest uptrends, investors experience declines against the
main trend. These are referred to as corrections. At other times, markets
correct more than expected in a short period of time. Such occurrences are
called crashes. Both of these can lead to a misunderstood situation called
capitulation. We ll look at these three concepts, their connections and what
they mean for investors. (To learn more about market direction, read Which
Direction Is The Market Heading?) Wall Street s White Flag
In stark terms, capitulation refers to market participants' final surrender to
hard times and, consequently, the beginning of a market recovery. For most
investors, capitulation means being so beaten down that they will sell at any
price. True capitulation, however, doesn t occur until the selling ends.
When panic selling stops, the remaining investors tend to be bottom fishers and
traders who are holding on for a rise. This is when the price drop flattens
into a bottom. One problem with calling the bottom is that it can only be
accurately identified in hindsight. In fact, many traders and value investors
have been caught buying into false bottoms only to watch the price continue to
plunge - the so-called falling knife trap. (Traders can try to trade this
phenomenon. Check out Catching A Falling Knife: Picking Intraday Turning Points
for more.)
Capitulation or Correction?
When and where a market should bottom is a matter of opinion. To long-term
investors, the series of retracements inside of a long-term uptrend are
referred to as corrections in a bull market. A bottom is formed after each
correction. Each time the market forms a bottom in an uptrend, the majority of
investors do not consider it capitulation, but a corrective break to a price
area where investors want to reestablish their long positions in the direction
of the uptrend. Simply put, early buyers take profits, pushing the stock low
enough to be a value buy again.
An investor can tell a correction from capitulation only after the trend has
turned down and the downward break has exceeded the projected support levels
and established a new bottom from which to trend up again. The question should
not be whether capitulation is taking place, but whether the market has, in
fact, bottomed.
Connecting to Crashes
A crash is a sharp, sudden decline that exceeds previous downside price action.
This excessive break can be defined in real dollars as a market percentage or
by volatility measures, but a crash typically involves an index losing at least
20% of its value. (To learn more, read The Crash of 1929 Could It Happen
Again?)
A crash is distinct from capitulation in two important ways. First, the crash
leads to capitulation, but the time frame of the actual crash doesn t
necessarily mean capitulation will follow immediately. A market may hit
capitulation and the bottom months after the initial crash. Second, a crash
will always end in capitulation, but not all capitulations are preceded by a
market crash.
In the long view, a crash occurs when there are substantially more sellers than
buyers; the market falls until the there are no more sellers. For this reason,
crashes are most often associated with panic selling. Sudden bearish news or
margin call liquidations contribute to the severity a crash. Crashes usually
occur in the midst of a downtrend after old bottoms are broken as both short
sales and stop-loss orders are triggered, sending the market sharply lower.
Capitulation is what comes next. (Learn more about buying on margin and margin
calls in our Margin Tutorial.)
Finding the Bottom
A bottom can occur in two ways. Short selling can cease or a large buyer can
emerge. Short sellers often quit shorting stocks when the market reaches
historical lows or a value area they have identified as an exit point. When
buyers see that the shorting has stopped, they start chasing the rising offers,
thereby increasing a stock's price. As the price begins to increase, the
remaining shorts start to cover. It is this short covering that essentially
forms the bottom that precedes an upward rally.
As mentioned, the emergence of a large buy order can also spook shorts out of
the market. It is not until the trend turns up, however, that one can truly say
that buyers have emerged and capitulation has taken place. Large buyers
occasionally try to move the market against the fundamental trends for a
variety of reasons, but, like Sisyphus and his boulder, their efforts will fail
if the timing is wrong. In timing capitulation, investors have to choose
between going long on a rally started by short-covering or getting back in when
actual buying and the bottom has been established. (For more, see Profit
From Panic Selling.)
Catching the Turning of the Trend
Technical analysis can help determine capitulation because subtle changes in
technical indicators such as volume are often heavily correlated with bottoms.
A surge in volume is an indicator of a possible bottom in the stock market,
while a drop in open interest is used in the commodity markets. Trend
indicators such as moving average crossovers or swing chart breakouts are ways
that chart patterns can help identify when a bottom or a change in trend has
taken place.
Tricky Terminology
Crashes and capitulations are most often associated with equities, and the
language is slippery. If we use percentage moves to determine whether a crash
or capitulation has taken place in the stock market, then why is a downward
move of over 20% in the commodities market always called a correction rather
than a crash?
Moreover, one market event can also act as a crash, correction and
capitulation. For example, a gradual break from 14,000 in the Dow Jones to
7,000 can be called a 50% correction of the top, but if the market drops the
last 2,000 points in a short period of time, it will be called a crash. If the
Dow then makes a bottom at 7,000, it will be called capitulation.
Real-World Crashes and Capitulations
Good historical examples are the Black Mondays of 1929 and 1987. In both cases,
investors ran for the exits, producing big market drops. In 1929, the drop was
prolonged as bad economic policies aggravated the situation and created a
depression that lasted until World War II. The crash occurred in 1929,
capitulation occurred in 1932, and then the actual rally occurred despite the
economic conditions at the time. (For more, see What Caused The Great
Depression?)
In 1987, the drop was painful, but stocks started to climb within the next few
days and continued until March 2000. Surprisingly, the sudden drop in the stock
market in October 1987 was called neither a capitulation nor a crash. Other
euphemisms such as "correction" were used at the time. While some people
realized what had occurred, it took the media years to label the event
correctly. (For related reading, check out October: The Month Of Market
Crashes?)
Bottom Line
After studying price movement, one can conclude that crashes and capitulation
are parts of the same process. When a bottom occurs, traders can buy into the
uptrend and watch the new support and resistance zones form as they navigate
the rally until the next downtrend. So for them, it represents an opportunity.
Long-term investors can also benefit from capitulation by getting into value
stocks at extremely low prices. So, even though crashes, corrections and
capitulations are bad news for investors holding the stock, there are still
ways to profit. (Should you get out of a stock after a drop? Read When To Sell
Stocks and To Sell Or Not To Sell for more.)
by James Hyerczyk