Thursday, November 24, 2011

Capitulation - how you recognize and trade it


One of the well-recognized terms from the tape reading terminology is Capitulation - often mentioned and often misunderstood. Many apply it in an overly broad sense, labeling any new low as capitulation; some believe that buying into selloff makes them winners almost by default - after all, everyone heard about necessity to go against the crowd, right?

There are two important things to keep in mind about this concept.

First is, bottoms are not always being formed by the capitulatory selloff (V-shape). Sometimes it's a slow grind shaping as a dish; sometimes even with capitulation it's still not that easy - weak initial bounce often leads to another drop  and new low is being made sending a stock into panic.

Second, and most important to remember. You  probably noticed that wherever you find the description of the concept of capitulation, it's still just a concept - meaning, there is no measurable component to it. There is, to my best knowledge, no percentage of the drop that quialifies selloff as capitulation. Name any particular number, and you will inevitably find a whole lot of cases where it was exceeded. There is a good reason for that: if there were a certain measurement for capitulation that guaranteed ultimate low, everyone would be insanely rich waiting for it and buying it... and no one would be buying a second earlier. But then again, why would anyone SELL at that ultimate low which has been already proven to be an ultimate one?... And if the answer is "no one," then from whom the bottom hunters would buy at that same bottom they were hunting?

Thus, capitulation is either:

- can not be computed and quantified as it's an emotional state, panic, total disarray leading to a free-fall - but not being quantifiable, it's in the eye of a beholder, which meakes "getting a read" on it quite discretionary; 

or

- can be computed to a certain degree IF you somehow know the amount of shares that were held by different stakeholders, and see that roughly that amount is being traded in a very short period of time (again, discretionary component) during very steep selloff (once again, steep by what standard? on what chart?).

No doubt, sometimes experienced traders get it right by gut feeling which is a product of vast experience. By no means it's a fool-proof process for any of them, and you will always see arguments about whether this particular selling already constitutes capitulation or not yet, whether capitulation is going to be the case on this particular bear market or not. This concept is necessary to understand, but it doesn't mean that once you understand the concept you can spot the capitulatory type of bottom. That's why I am always advocating for a different type of bottom-fishing - one that is based on:

- letting go of the idea of buying THE low, 
- waiting for a stock to come out of free-fall, form a recognizable reversal formation,
- buying when such formation offers chart-based opportunity free of emotions.

Such approach will never get you in on the exact low - leave that to amateurs to try and brag about those rare instances when they get it right. In exchange, such approach will give you a repeatable reliable method of trading the trend reversals.

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