Capitulate or Buy - TheStreet

In Wednesday's article I covered some common trading errors that many of us make at one time or another. In that article I referred to capitulation days -- high-volume, wide-ranging down days that come at the end of a downtrend.

Today I want to examine what actually causes those capitulation days, and share a way to profit from them.

I have said many times that analysis of price and volume data (i.e., looking at charts) is a window into the emotions and wallets of market participants. The efficacy of technical analysis begins and ends with the generally accepted fact that market participants will react in a similar fashion to the same event. This common behavior will often be reflected in identifiable patterns. Many chartists tend to ignore the underlying cause of a pattern and instead just look at triangles, cups and channels, without considering the forces that create those pretty little patterns.

I strive to understand what forms these patterns, because it helps me focus on what really matters -- the psychology of the crowd. I believe this leads to fewer mistakes, because I am a charter member of the mob that controls the movement of stocks. We all are.

So if we can understand what creates a capitulation day, then we can have a better chance of differentiating between this type of reversal pattern and just another high-volume continuation pattern.

Can Things Get Any Worse?

As an example, let's say the stock of your favorite pharmaceutical company is sliding lower and lower each day. The news isn't good. Sales are down. What's worse, several patents are about to expire, and a generic drugmaker like

Barr Labs

(BRL)

is set to roll out its version at a fraction of the cost. And there are rumors that the new drug currently in phase III trials might not be the miracle cure it was cracked up to be. Then one day the news breaks that the FDA has denied approval of the miracle drug. The stock plunges on huge volume! What happens? Capitulation.

Remember that there is a buyer and seller for each stock. The inexperienced shareholders will sell their stock. They'll say, "Wow, how can things get worse? I've got to sell!" They've been extremely patient as the stock has been trending lower, believing in the company and hoping that the new drug would turn the company around. But this is the last straw, so they sell -- and mark the bottom of the downtrend.

Experienced traders will also ask, "How can things get worse?" But they buy instead. Why? Because they know that if it ain't getting worse, it's gonna get better. It's time to buy, because the market does not look back, it looks forward. If all the bad news is known, then there is no outlying catalyst to flush out any more aggressive selling. It's the perfect buying opportunity.

Capturing Capitulation

If we get a handle on what is causing the selling, then we'll have a better chance of staying away from that proverbial falling knife. Two stocks that exemplify this concept are

General Motors

(GM) - Get Report

and

Fannie Mae

(FNM)

.

General Motors

GM had been in a downtrend since January 2004, as its market share has been shrinking and pricing power has been AWOL. So Wednesday's announcement that it expects a $1.50-a-share loss for the first quarter was the last straw for a lot of shareholders. They sold.

Are they done yet? No, but they're close.

Is this a capitulation bottom? I think it is, but it's not yet time to buy.

When the previous day's high is eclipsed by the current day's high, then we know that the frustrated sellers are finished. Will GM then begin an uptrend? No way, but it'll be good for a trade.

Fannie Mae

On the other side of the coin is Fannie Mae. As I listened to Jim Cramer lament on "Mad Money" that he did not know what this stock was worth, I was drawing a support line down at $20.

First, the horizontal bars at the $60 to $80 level indicate a high amount of trading volume within that $20 range. Therefore we know that a great deal of emotional and financial commitment lies at this level. So now that shares are falling beneath the $60 level, all those buyers in that high-volume zone are now losers. They'll sell, putting more selling pressure on the stock.

Will it fall all the way to $20? Anyone who says with certainty that it will fall to $20 is either a fool or a liar, because nobody knows where all the bodies are buried. And that's the point.

Thursday's selloff is unlikely to be a capitulation by the bulls, because there is still a great deal of uncertainty surrounding the company. All we know is that the company will miss the regulatory deadline for filing its financial report for 2004 and may have to record an additional loss of some $2.4 billion. We know that company employees falsified signatures and accounting records. Is this the whole story, or just the tip of the iceberg? The investigation is ongoing, so we don't know if things can get worse yet.

Even though the stock has been trading lower since mid-January, this high-volume decline is just the latest in a series of declines. It might be tempting to try to catch this falling knife, but I wouldn't, because things might get worse.

Be careful out there.

Dan Fitzpatrick is a freelance writer and trading consultant who trades for his own account. His columns focus on quantitative strategies for trading and investing. Fitzpatrick is a member of the Market Technicians Association and manages The Stock Market Mentor, a Web site focusing on the proper use of technical analysis for trading and investing. At time of publication, Fitzpatrick held no position in any stocks mentioned, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Fitzpatrick cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send your comments to

dan.fitzpatrick@thestreet.com.