What is capitulation?

What is capitulation? CNBC Explains

Traditionally, the word capitulation describes a surrender between fighting armies. What is capitulation when it's used on Wall Street? What does it signify? We explain.

What is capitulation?

In simple terms, capitulation is when investors try to get out of the stock market as quickly as possibleand look for less risky investments. It's also described as panic selling. It's usually based on investor fears that stock prices will fall further than they have.

Capitulation is usually signaled by a decline in the markets of at least 10% in one day.

In getting out of the market, investors give up any previous gains in stock price. That means they take a financial loss, just to get out of stocks. The thinking is: take a smaller loss now rather than a bigger one later.

Real capitulation involves extremely high volume-or high numbers of traded shares-and sharp declines in stock prices.

Why do investors capitulate?

Suppose a stock starts dropping in price. There are two choices. Investors stick it out and hope the stock begins to appreciate-or they can take the loss by selling the stock.

If the majority of investors decide to wait it out, then the stock price will probably remain stable. But if the majority of investors decide to capitulate and give up on a stock, they start selling and that starts a sharp decline in a stock's price.

Are there any benefits from capitulation?

Only for those buyers ready to swoop in. After capitulation selling, common wisdom has it that there are great bargains to be had in the stock market. Why? Because everyone who wants to get out of a stock, for any reason, has sold it. The price should then, theoretically, reverse or bounce off the lowest price of the stock.

In other words, some investors believe that capitulation is the sign of a bottom and a chance to get stocks at a cheaper price than before the capitulation took place.

Is capitulation a way to gauge the markets?

Not at all.Capitulation is very difficult to forecast and use as a way to buy or sell stocks. There is no magical price at which capitulation takes place. Certainly during the trading day, stock prices and volumes are monitored and some measurement is used to determine if a capitulation is taking place and will remain so at the end of the day.

But most often, investors and market watchers look back to determine when the markets actually capitulated and see how far stocks have fallen in price for that one day of trading.

When have there been capitulations?

The stock market crash of 1929 that helped lead to the Great Depression, is a capitulation. In fact, it had more than one day of it.

On Oct. 24, 1929-what's known as Black Thursday-share prices on the New York Stock Exchange collapsed. A then-record number of 12.9 million shares was traded.

But more was to follow. Oct. 28, the first "Black Monday," more investors decided to get out of the market, and the slide continued with a record loss in the Dow for the day of 38 points, or 13 percent.

The next day, "Black Tuesday," Oct. 29, 1929, about 16 million shares were traded, and the Dow lost an additional 30 points.

More recently, there was a massive sell off or panic selling of stocks on Oct. 10, 2008, in what can be considered a capitulation. Not only U.S. stocks, but global markets had major declines of 10 percent or more on one day.

Investors flooded exchanges with sell orders, dragging all benchmarks sharply lower. It's believed fears of a global recession and the U.S. housing slump sparked the sell-off.