What is Stock Capitulation?
How does it work?
What are the essential elements you should know!
In this article, I will break down the notion of Stock Capitulation so you know all there is to know about it!
Keep reading as I have gathered exactly the information that you need!
Let’s see what stock capitulation means, how it happens, and why!
Are you ready?
Let’s get started!
What Is Stock Capitulation
Stock capitulation refers to an investor’s decision to sell his or her shares when the stock prices are declining thereby giving up any paper gains that could have been realized otherwise.
Quite often, investors may choose to capitulate when the financial markets fall rapidly due to a crisis or further to negative economic news in general or about the specific stock being capitulated.
In essence, you can say that “stock capitulation” is when an investor is “forced to sell” to avoid further losses in stock prices going down further.
In general terms, stock capitulation can happen when:
- There’s an economic downturn or financial crisis
- There are economic indicators that affect investor decisions
- Stock price is dropping for a prolonged period of time
- There’s a large sell volume
Investors may also sell their shares for various reasons:
- During market corrections
- During a financial crisis
- In bear markets
- Due to panic
- Based on speculation
- Psychological reasons
However, when the investors are selling off their shares, it may be difficult to determine that “capitulation” is taking place.
In most cases, once the stock price drops and eventually starts coming back up, investment professionals may agree that stock capitulation was in play but it may not be easy to spot it in the spur of the moment.
To understand the meaning of stocks capitulation, it is useful to define the term “capitulation” to start.
According to the Merriam-Webster dictionary, capitulation is defined as:
The act of surrendering or yielding
To capitulate means to:
- Give up
- Sell off
The act of capitulating is the act of letting something go or giving up something.
Stock Capitulation Definition
Now, let’s define stock capitulation.
According to Investopedia, stock capitulation is defined as follows:
Capitulation is when investors give up any previous gains in any security or market by selling their positions during periods of declines.
In other words, an investor capitulating a stock position is one who is giving up potential gains in stock in order to sell.
Why Do Investors Capitulate
There are many reasons why an investor may decide to capitulate a stock position.
In some cases, the decision is based on objective economic signals while in other cases it may be purely psychological.
Very often, you may see capitulation selling in the stock market during economic downturns or when there’s a market correction taking place.
An investor may also decide to capitulate securities when there’s a high volume of trading on a stock and where the stock price has been declining over a long period of time.
That may signal to the investor that others are selling off and that it may be best to liquidate the stock instead of letting the share price go further down.
There are instances when traders and investors sell off their position based on subjective and psychological reasons.
When an investor sees that everyone else is selling and the price is rapidly going down, the investor may feel “forced” or “pressured” to sell.
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What Happens After Stock Market Capitulation
For many traders and investors, stock market capitulations provide them an opportunity to invest and make money.
The reason is quite simple.
When investors and stockholders sell out during an economic decline or simply because they see a high volume of shares being sold for a stock, they may find that the stock price may trade below its fair market value.
As such, purchasing securities undervalued by the market can represent a great opportunity to invest.
One of the most famous investors in history, Warren Buffett, is a well-known value investor who buys stocks that are undervalued in the market (that may include events of stock capitulation).
Traders buying stocks after capitulation believe that the stock price will eventually go back up to its normal (or expected) levels.
Those who perform technical analysis on the stock consider that the capitulation selling will bring the stock to its lowest price point making it advantageous to buy at that point in time.
How To Identify Stock Capitulation
In some cases, it may be easy to detect that investors are massively exiting a stock position.
However, in other cases, it may not be that easy to detect.
There are generally certain factors and events that may occur leading investors and traders to suspect the occurrence of shares sold in mass:
- Negative economic news
- Negative overall market sentiment
- A decline in many stock indices
- A decline in stock price
- High selling volumes
- Lower earnings
- Important short-selling activity
- An elevated put option to call option ratios
- Negative news
More sophisticated traders may use technical analysis to detect the presence of capitulation in an attempt to time market entry to purchase shares undervalued by the market.
Candlestick charts may be used to make buying and selling decisions particularly when there are important selling activities on a stock.
The objective is to predict the lowest value the stock may trade in the selling frenzy so that a prediction can be made as to when the stock price will start climbing back up.
When the price hits its lowest mark, hammer candles are typically formed at the end of a selling frenzy whereas shooting star candles form when the buying frenzy is over.
There are many technical analysis methods used to predict the direction of a stock price so you can decide as to the most optimal time to buy versus time to sell (market timing).
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Stock Capitulation Example
Let’s look at an example of stock capitulation to better illustrate the concept.
Imagine that you hold $50,000 shares of Company ABC trading at $100 per share.
Following certain negative news about the economy, combined with bad earnings reported by the company, and declining overall markets, the stock price starts declining.
Within a matter of a week, you lose 10% of the value of your investment.
Another week goes by and you lose a further 15%.
Another week goes by and you lose another 10%.
At this point, you’ve lost a total of 29% on the value of your shares and still see that the stock price is still going down.
After a month of holding your stock position, you need to make a difficult decision to either keep the stock (and perhaps lose more money) or sell it now and cut your losses now.
If you choose to keep the stock and most other investors do the same, the stock price may go down but can stay relatively stable.
However, if you realize your loss by selling your shares and many other stockholders do the same thing, then the stock prices will continue dropping (that’s what we call capitulation selling).
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Capitulation Stock Takeaways
So there you have it folks!
What does it mean to capitulate in the stock market?
What is the significance of capitulation selling?
Stock capitulation refers to the point in time that investors decide to liquidate their stocks or securities, realize their losses, with the objective of preventing further loss.
In some cases, the stockholders sell for valid and objective reasons while in other cases it may be based on speculation or subjective reasons.
Typically, the extent of the decline in the stock price can only be truly evaluated when the stock reaches its lowest point and the stock price starts increasing again for an extended period of time.
Day traders, sophisticated investors, and other investment professionals may look for investment opportunities by spotting massive selling of stocks where investors are giving up their gains can capitulating.
For market professionals, when the stockholders are selling off, they assess the possibility of purchasing the stock based on the expectation that the fundamentals of the stock remain strong and that the price will bounce back.
Traders that are into technical analysis may use various analysis methods like candlestick charts to identify a capitulation taking place.
I hope I was able to answer your questions about what stock capitulation means, when it happens, why it takes place, and generally how it works.
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