Michelle B submits:

LP, in a recent comment to this blog entry, expressed interest in understanding trades based on capitulation. Capitulation means that there are no more sellers for the moment, and the stock price will rebound sharply. The most important aspect is not to confuse capitulation with the low-grade drip, drip of continuing distribution, better known as the infamous falling knife. The two down legs shown in the chart below are distributive in nature, though quite vigorous, while the third and final leg down represented capitulation. Another important aspect is being able to know when they are happening—in my case, it’s my watching the hi/lo ticker that finds these kinds of trades.

At first, the beginner needs to focus on identifying the basic capitulation pattern and differentiating it from on-going distribution, and then learning the variations which can occur—set-ups with a different number of down legs, different bottoms other than a V-shaped one, like a double/triple bottom, reverse head and shoulders, cup and handle, and different time frames for the support level where the capitulation reversal takes place.

The below chart summarizes a classic capitulation setup that happened in the Q’s this past Thursday, March 29.

Another feature is that these trades often are not stocks making new 52 week lows. In addition, they often have no traceable news which can explain the decline, and they frequently occur in the afternoon.

Capitulation checklist:

1) Have a means of being able to identify stocks which may be in the process of capitulating.
2) Check for any news which could explain the extreme selling.
3) Verify substantial support—price, trend line, and moving average supports—on different time frames, including the daily.
4) Look for the price and volume pattern (especially the downward curvature morphing into a straight line) plus the time of day—afternoon—which is markedly correlated with capitulation.
5) Identify your price target, calculate your risk, size your lot appropriately, and enter the trade either on the first pullback on lower volume than the volume which occurred during the first capitulation bounce, or when price surmounts the first new resistance on the developing reversal. In other words, wait for the beginning of the reversal to show itself.
6) Exit per partial profiting out at various resistance levels, or by complete profit-booking once your target is reached.