What is the capitulation period, are we in one?

What is Recency Bias?

What is Recency Bias?

Since we have experienced consecutive aggressive FII selling on ‘Thursdays’ followed by Black Fridays, there is a windy buzz there we are all in the ‘Capitulation period’.

We all are well aware that panic trading acts as a huge hole in the ship (market) which can significantly damage a market condition and burn out your capital from your portfolio. 

In the same way, there are certain undesirable situations where panic selling happens. 

And such a condition is called ‘capitulation’. 

Technically, capitulation is a condition referring to panic selling.

This panic selling can be an outcome of the actions of traders including FIIs, DIIs or retail. 

When institutional investors take action, it builds up momentum in the market and causes a dramatic decline in company stock prices. 

In such situations, an investor willingly gives up all gains to exit the market due to fear and uncertainty. 

In most cases, it is observed that naïve investors liquidate all or the majority of their holdings to protect themselves from the fear of the unknown.

Capitulation does not build up overnight, it is a result of a series of triggered investor and trader actions.

For example:

When indices decline by 10%, we say ‘Bear market’ has occurred! 

But in the bear market, it is not necessary that your portfolio is down by 10% as well.

There must be some stock when inverse correlation as well, that because you have diversified your portfolio!

And for instance, if stock A in your portfolio has declined more than 10%, you as an investor are left with two options!

Either to wait for a correction and average the stocks or sell your holding, book your losses and stay away from the market until you gain confidence all over again.

If the majority of investors choose the latter and decide to exit their positions in the market, it can cause a dramatic fall in stock price triggering a wave and creating an illusion that there is something serious unfortunate happening expected in the economic arena.

But what exactly causes capitulation?

Note that Capitulation can be expected in any market condition but most often statically it is observed when the market is drifting. 

One can get a clear picture of Capitulation by analysing the trading volume with a price decline. 

If this prolongs, the market finally hit its bottom point.

The great news is that, after such a steep downtrend, a robust rally is seen.

So, when experts start observing such glimpses in the market, they first analyse the trend of the ‘Fear Index’ also known as ‘Volatility Index’, to get a rough estimation of the bottom of the market.

The high volatility index indicated high fear and hence the parameters to look out for are trading volumes and option trading ratios.

If these parameters are significant, then is an alarming ‘Capitulation’ situation expected.

Experts see capitulation as an opportunity for investors with a good bargain buying.

But this an often at the last phase of the situation when prices hit the bottom!

And we all know that we can only predict the bottom but pin it out!

Let us have a clear understanding of the signs of Capitulation in detail…

Change In Trading Volumes

Capitulation influences trading volumes.

Massive unusual volumes accompanied with price decline for a couple of days is observed and such situations usually last long.

Mutual Funds Cash Withdrawals

When the investors’ sentiments are affected, then mutual funds take instant action.

These actions are usually withdrawing the humongous amounts of cash by selling funds.

Derivative Trading

There is seen that during such circumstances there is a rise in participation in derivative trading by purchasing put options.

This is a clear indication that traders are betting against a market rise and trying to safeguard or hedge against a further price decline.

Negative Sentiment 

We have seen that there is selling and hedging sentiment everywhere in the market.

This simply translated that investors/traders are losing confidence in the market and its future and are in the mode of ‘giving up’ until they think markets are favourable.

Beware of Capitulation

The biggest drawback is that one cannot predict Capitulation in advance.

The technical analysts usually trace Capitulation using candlestick charts, but for an abrupt change to build up takes time.

And hence, no foresee for warning about Capitulation beforehand!

Conclusion

Spotting capitulation before it happens is next to impossible.

Although, one of the major indications of capitulation, that the market has hit bottoms, an investor can take this as a literal parameter.

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