Measuring the risk when catching falling knives. So great?
As a reminder, I have been writing about capitulation in the following posts.
Since capitulation is a mean reversing tool, and, by definition, we don’t wait until the trend shows signs of reversing, we are catching the proverbial “falling knife”. This means that there is always the risk of further declining prices after the initial long commitment has been made following the capitulation signal.
However, as we will see in this post, if the past is to serve us as a guide, in most instances there is very little further falling left.
In this post, I explained the time-wise accuracy of capitulation in signaling bottoms. It suffices to be reminded here that the median time from the signal to the actual bottom is just 2.5 days. In other words, as far as time is concerned, capitulation tends to be very close to the actual day of the bottom, which suggest that, in good logic, percentage-wise the knife should not fall very much after the capitulation signal.
That post also dealt with the extent requirement. That is, the further decline that follows capitulation.
In this post I will further elaborate the extent aspect under the perspective of risk. How deep tends to be the further decline following a capitulation signal?
The median decline from the signal to the actual bottom is -1.4%, whereas the average decline to the bottom is 4.4%. The noticeable divergence between the median and the average is due to the fact that most of the capitulation signals are given very close to the market bottom. 9 out of 16 signals have been given within 3 days or less to the actual bottom, and hence, the subsequent decline was muted. However, there have been some other instances where the final bottom was more distant in time and, even though time does not directly correlate to extent, the subsequent decline was larger. So we could say that in most instances there is a very negligible subsequent decline, but exceptionally (2002: -8.4%; Oct 2008: -20%, Nov 2008: -8.8% and Feb 2009: -8%) there have been more sizeable declines. Such rare occurrences increase the average further decline to the bottom but, since most of the signals are close to the bottom, the median remains small (-1.4%). Therefore, the median is more representative of the accuracy of the indicator than taking the average. However, what happened in 2008 and 2009 (three capitulations all of them far from the actual bottom) warrants a specific post. The 2008-2009 period was so nasty to investors that it is worth to devote one specific post to analyzing how Schannep did navigate through this turbulent waters. As an appetizer it suffices to be said now that Schannep lost much less than buy and hold.
If we take out the October 2018 further decline of -20%, we see that in no instance there has been a market decline exceeding -10% following capitulation. Hence, we can reasonably assume that the odds favor a decline of modest proportions. Most of the time a very small one (in the vicinity of -1.4%) some other rare times around -9% or -10%.
However, Schannep does not recommend to go long 100% after a capitulation signal. Depending on the way you apply Schannep’s Dow Theory either a 25% or 50% position is opened at the close of the capitulation day (or next day’s open). This is the subject for the next post. Hence, if you are likely to undergo in a very extreme worst case scenario a further nominal loss of -10% but you only have committed 25% of your trading capital, your actual loss is quite muted, just -2.5% In other words, even in those rare instances where catching the falling knife results in sizeable declines following the signal, the total loss is well contained.
Even if we take the -20% further decline following the October 2018 signal, a 25% long commitment would have result in a loss of just 5%, which is bearable and does not put you out of the game (the key issue is to survive the storm in order to have powder dry when future good times come).
You can find all the data concerning capitulation on Schannep’s website:
All in all, following the capitulation signal the “knife” has little left to further fall. In most instances we are calling the exact bottom or we are in the vicinity of it percentagewise. Even when further declines ensue, the loss incurred is well contained.
Hence, it is important to know the intricacies of the sizing of each long commitment after capitulation. When do we buy 25%, when do we go to a full or total invested position? What is the risk when we transition to a full position? This will be the subject of the next post.
The Dow Theorist