Bounce it back – understanding the rebounds

Investors’ love rebounds – especially those who want to lock in the long-term value of a stock. Over time, stock experiences cycles where there are moments of decline and upward trajectory. These fluctuations add up to trace the general trend of the stock over time. 

A rebound is a case where a stock regains its value after a period of decline. Consider stock of a mining company that has just struck a massive deposit of gold. Assume that the company has been posted falling revenues over the past four quarters. As a result, investors have been dumping their stock because no one wishes to hold a rock in the hands eventually.

Price Action Trading

Figure 1

After the news of the find break out, investors rush back to the company’s stock because they believe a turnaround is around the corner in terms of revenue. The rising demand for the stock leads to a sharp rise in its value. The scenario can be referred to as a rebound.

Rebounds frequently happen both in the short-term and in the long-term. They could be sharp – as in V-shaped – or drawn out. Drawn out rebounds form a U-shape. Watching rebounds is one of the most profitable stock trading strategies. However, one requires a more profound knowledge of how and why rebounds happen to exploit them for profitable stock trading.

Rebounds under the microscope

Rebounds behave differently depending on the asset and the prevailing economic conditions. Let us consider two scenarios to see how rebounds behave.

In the first scenario, consider Amazon.com, Inc. (NASDAQ: AMZN) stock so far in 2020. As a series of lockdowns and quarantine restrictions because of the COVID-19 pandemic began to roll out in late February in the US and abroad, investors began to short the AMZN stock. As a result, the stock tumbled about 22% to $1,676.61. 

AMZN stock Year-To-Date, 2020

Figure 2: AMZN stock Year-To-Date, 2020.

But the decline did not last a month before the market realized that the pandemic period could be a blessing for Amazon’s e-commerce and logistics business. In its recent release for Q2 2020 earnings, the company beat revenue estimates by more than $7 billion to $88.91 billion. 

It seems investors anticipated the revenue blow out because they started trooping back to the AMZN stock in mid-March. Interestingly – and as explained earlier – rebounds behave differently in the short-term and long-term. For example, the AMZN stock rebounded by 48% to settle at $2,474.00 in about six weeks between March 12 and April 30. But when viewed from a long-term perspective, the AMZN rebounded by about 89% between March 12 and July 31, four months and three weeks. 

The second scenario we shall consider is the case of the S&P 500. The index began to decline at the same time as the AMZN. The decline was broad because investors were anticipating a recession because of the COVID-19 pandemic. The S&P 500 declined 33% to 2,237.40 on March 23, but after that, rebounded by 46% to 3,271.12 as of July 31.

S&P 500 year-to-date, 2020

Figure 3: S&P 500 year-to-date, 2020.

Curiously, the S&P 500’s rebound has been long and flatter compared to that of AMZN stock. What can one deduce from this phenomenon? The difference in the gradient of bounce tells you that different assets have different sensitivity to market activity. Amazon, for instance, is a single stock whose movement is pronounced. The S&P 500, on the other hand, comprises many stocks, each of which rebounded differently – others continued to decline while others remained unchanged in the period in focus.

Trading rebounds

Rebounds present an opportunity for traders to score great returns if incorporated in stock trading strategies. Trading rebound is as easy as it sounds. However, one needs to build a good strategy around them.

The first and easiest strategy is to catch stocks on the rebound. Once in a while, a good stock wavers, and the market descends into a sell-off. Consider the AMZN stock cited earlier. Amazon.com is a giant in the e-commerce space and other spheres of business, such as technology. Such a company with strong foundations would rarely see its stock tumble the way it did early this year.

When COVID-19 triggered a sell-off of AMZN stock, a smart investor would have anticipated a major comeback. By mid-March, it was apparent that Amazon would reap big from the lockdowns that authorities imposed in many places globally. One only needed to time the sell-off floor to catch the rebound when it began to form.

However, this strategy only works when the company has an underlying strength that is sufficient to sustain a major rebound. If a stock declines because of the company’s structural weaknesses, then a bounce could be a false one. Interestingly, one can also exploit such false rebounds.

Traders term the false rebounds as a dead cat bounce back. This strategy assumes that a declining stock is destined for deeper falls, perhaps because the company is not doing well. There is no hope of a convincing recovery in revenues soon.

Consider the Boeing (NYSE: BA) stock. In mid-March 2019, the stock began to decline after a Boeing 737 Max 8 crashed, the second one in five months – the two crashes killed a total of 346 passengers. It later emerged that the planes had some unfixed software issues. 

Boeing stock from Dec. 2018 to date

Figure 4: Boeing stock from Dec. 2018 to date

The aftermath of the events saw the BA stock take a beating from the market. Early July 2019 looked like the BA stock would rebound, but the gyration continued. When using the dead cat bounce back strategy as part of your stock trading strategies, such moments of attempted rebounds present an opportunity to short the stock. It is because there is too much baggage weighing down the stock to mount a meaningful bounce-back. Even if it bounces, the cat is still dead!

Conclusion

Rebounds do happen, but whether they are sustainable depends on the strength of the underlying business. Investors must have this information if they want to develop winning stock trading strategies built around the rebounds.

We saw that the fundamentals for Amazon are strong, and that is why the stock has maintained a positive gradient since bottoming out in mid-March 2020. It would have been a smart play if one bought the AMZN stock at the March trough.

On the other hand, as a company, Boeing has encountered many challenges since two of its planes crashed in the space of months. The company has had to ground the Max 8 series because of major software problems. It would be a colossal mistake if an investor mistook a rebound’s positive bump with such information in mind. In such a case, the best move is to short the stock further because the false rebound is just the bounce of a dead cat.