Capitulation by its very definition means to surrender or give up. In the context of price action, this means we’re seeing a currency or equity either sell off in an extremely short period of time after a large push to the upside, or we’re seeing it jump up in price quite aggressively after a large push to the downside.

The easiest way to identify capitulation in the market is to look for a large “V-shaped recovery” in the market, where price pushes in one direction (sometimes because of high-impact news releases), and retraces or sees a reversion to the mean.

In order to practice this type of trade setup, we highly suggest looking for huge reversals in hindsight and trying to break them down on the 4-hour, 15-minute, and 1-minute timeframes to find trade setups that make sense within your plan. By looking at historical price action and analyzing how price played out in these moves, you can get a sense of how to play them by looking for commonalities and confluences in the price action so you know what to look for next time you encounter a capitulation play in the live market.

Capitulation Is Price Exhaustion

The theory behind capitulation is that price becomes so over-extended in one direction that investors and traders start to exit out of their position to realise profits so quickly that it causes the price to push in the opposite direction.

The easiest way to identify price exhaustion and price capitulation are to look for a large and overextended move and to start observing price to see if the momentum is starting to fade. Prices will usually want to return to a more fair value, and we can identify potential price exhaustion by looking at price to see if it starts to “round off”

As shown in the illustration above, if you notice the highs start to taper off and get shallower and shallower after each internal structure break, after a huge jump in prices in the market, prices may be due for a significant pullback as it seeks to retrace and return to a more fair value.

How To Trade Capitulation In The Markets

In the example shown above, we can see how price ran up quite aggressively, briefly respected a 15-minute supply zone to the left, then eventually swept the liquidity that was resting above it, and started to lose it’s momentum (rounding off price) as the higher highs on the 1-minute chart started getting shallower and shallower compared to the last 1-minute internal structure breaks.

Once we start to see price break 1-minute internal market structure we can start hunting for a retracement short play in anticipation that price is exhausted and wants to retrace in order to revert to the mean and re-balance. As shown in the example above, we can take the extreme 1-minute supply entry after demand has failed and hold our short position all the way to the demand zone sitting below.

The Risk of Taking Capitulation Trades

While capitulation trades can be very rewarding as shown in our previous example, they also come with a lot of inherent risk. A lot of the time you’ll be trading against orderflow (internal structure) or swing structure on the 15-minute timeframe, meaning you don’t have price on your side.

You’re also in some instances trying to “catch a falling knife” to call the top or bottom of a big move in the market which in and of itself is a very risky way to get in. Remember, that just because we think price is capitulating, doesn’t mean it can’t continue to push up higher before retracing. It also means that price may just be going “parabolic” in one direction or another and won’t retrace for a long time.

That being said, with all the risks taken into account, this type of trade can be great for hedging a position that you may have caught if you think price is starting to capitulate!

Knowing When To Take Capitulation Trades Or To Stay Out

Taking capitulation trade setups really is a double-edged sword and should only be used in very particular situations in which reward really outweighs the risk, and where there are additional confluences on the higher time frames to justify getting into a trade in anticipation of it retracing significantly.

If we see that price isn’t really sweeping liquidity to the left or isn’t respecting a level of supply or demand on to the left, you’ll generally want to stay out of trying to take a capitulation trade setup as there are no higher timeframe confluences to support that price is going to stop and retrace or reverse. 

The other reason we’d look to stay out of a capitulation trade setup is if we don’t see order flow clearly shift on the 1-minute or even 15-minute timeframes (if you’re being more conservative). We don’t want to just wait for 1 subtle failure of supply and demand in the opposite direction of the initial move, but rather at least two or more clear failures to justify starting to look for entries. Remember, we’re trying to trade against a whole lot of momentum!

At Phantom Trading, we like to take capitulation trades in certain circumstances where price is usually sweeping a significant level we expected to hold, and starts showing the early signs we discussed above that it’s going to “capitulate”. While we don’t always enter trades like this, we do tend to take them in very counter-trend scenarios where our overall risk is much higher, but where the reward of a winning trade makes it worth the small risk we’re putting on.

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Robert Castillo
FX Trader & Analyst
Writer & Editor

Rob is a funded trader from Toronto, Canada, and has been trading currencies, commodities, stocks, and cryptocurrencies for over 7 years. Outside of trading, he enjoys making music, boxing, and riding motorcycles.