Definition of capitulation. Betting for a mean reversion
We continue with our saga concerning “capitulation”. I
feel this saga is going to keep me busy for quite some time. Here you have the
link to the first post.
Capitulation is a bottom detector tool devised by Jack
Schannep. Thus, capitulation is by nature mean reverting. It does not follow
the established trend but it tries to detect the change thereof. Capitulation
has been devised only for the long side. When the market is severely oversold,
capitulation bets for a change in trend. I see capitulation as an elastic gum
which has been too stretched. Some contracting is due.
While betting for a mean reversal is kind of abhorring
for trend followers, Jack Schannep makes clear that both Charles Dow and Robert
Rhea were eclectic enough to depart from strict trend following on selected occasions.
I quote from Schannep’s website, which at the same
time, quotes Charles Dow and Robert Rhea:
“[a] word [capitulation] Charles Dow never uttered
but he clearly alluded to with his discussion of the final phase of bear
markets when he described “distress selling of sound securities, regardless
of their value…..” Robert Rhea described it as “a semi-panic
collapse (and) it is wise to cover short position and
even perhaps make commitments for long account” (emphasis in
original).
Therefore, if the indicator is sound we should be
pragmatic. Furthermore, as I will show in a future post, even if the indicator
were to fail on a rare occasion in the future our losses would be well
contained for three reasons: (a) On most occasions there are stops; (b) even
when the knife continues falling, the initial commitment suggested by Schannep
is modest (25% or 50% of total capital depending on the kind of trading); (c)
the indicator signals a “buy” on extremely rare occasions when the market is
really very oversold.
As I wrote in the first post of this saga, capitulation is important
for three reasons:
a)
It
creates more trades (not many, but something is something)
b)
The
trades are very good quality trades (in the sense that the money made greatly
exceeds the money lost, which amounts to a high Profit Factor).
c)
It
introduces a measure of diversification to our trading by introducing some mean
reversal trading. Strategy diversification, even though it does not necessarily
increase absolute performance, results in smoothing the equity curve (less
drawdowns). When trend following (strict Dow Theory) may be temporarily lagging
behind, mean reversion may shine.
While I feel there is some minor part of the indicator
which remains proprietary, the basic tenets of the capitulation indicator are
as follows:
1.
One
calculates a 10 week exponential moving average of the closing prices.
2.
One
calculates the ratio between today’s close and exponential moving average at
the close.
3.
If
the ratio reads 0.9 (that is for example, current close at 90 whereas the
exponential moving average stands at 100) and
such a ratio is confirmed by the
INDU, NYSE and S&P 500, then we have reached “capitulation”.
Once we have capitulation we are advised to buy on the
very same day close (with equations one can calculate the closing prices that
would render the ratio at 0.9 or below that figure one day in advance so that one can buy at the close) or at
next day’s open.
I created a capitulation indicator that plots the
current reading of the ratio between the current close and the 10 week
exponential moving average. Since weekly bars can be tricky (as the current bar
is not completed until Friday), I work with daily bars and avail myself of a 50
days (5 weeks) exponential moving average.
The coding in Easy Language® reads as follows:
input: length(50);
value1=average(c,length);
If value1>0 then value2=c/value1;
Plot1(value2, "ratioMA");
With the aid of TradeStation® I created three charts
each one containing one index (INDU or NYSE or S&P 500). Below I plot the
indicator which shows me the ratio. When the reading of the three charts falls
below 0.9 then we have reached capitulation.
My own indicators faithfully signaled capitulation the
very same day it happened (12/24/2018), so I needed not Schannep’s “crutch” in order to know
when capitulation occurs.
Here you have the one chart depicting the situation on
12/24/2018 (blue circle highlights the date) where the ratio fell below 0.9 on
the three indices. As I told you, I use daily bars and my software calculates
de 50 day (10 weeks) exponential moving average.
 |
| Capitulation on 12/24/2018. Chart created with TradeStation (r) |
Schannep in his
book analyses in depth the
concept of capitulation. Readers really intent on applying this indicator are
well advised to read chapter 8 (pages 79 to 95) of Schannep’s
book “The Dow Theory for the 21st Century”. There are no shortcuts.
This post is not enough. Go and read the book.
Schannep in his book makes
a conclusive case concerning the soundness of his indicator. He compares the
accuracy of “capitulation” when signaling bottoms against other well-known
similar indicators (i.e. the put/call ratio) and, if the past is to serves us
as a guide, capitulation emerges as the most accurate bottom indicator by far.
Furthermore, there is a
thing I particularly like about “capitulation”. It is its simplicity. Other
competing indicators are more complicated by design. The less parameters, the
better when it comes to creating a robust indicator. A ratio between the
closing price of 0.9 or less between the closing price and the 10 week
exponential moving average very seldom occurs. It really measures a much
stretched elastic gum. Since 1960 there have only been 16 instances of
capitulation. Hence, the accuracy of the indicator. So clearly, capitulation does not result in overtrading.
More about “capitulation”
here on Schannep’s website.
Well that’s all for today.
Next post will deal with what follows capitulation. We
will be studying further advances and declines (on rare occasions) following
the capitulation signal and the time such advances last.
Sincerely,
The Dow Theorist
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