Traders do not usually get excited by downward trending markets. However, if they understand and have the ability to anticipate patterns like the dead cat bounce, they can potentially take advantage of bear trends. The term “dead cat bounce” has been circulating on Wall Street for several years, with the earliest use dating back to 1985. It’s considered a part of technical analysis for stock trading. Such price patterns are only recognized with hindsight.
What is dead cat bounce?
Dead Cat Bounce(DCB) is a common phenomenon that occurs during periods of stress in the market. It refers to a behavioral bias from financial participants who think that the bottom of the markets has already been reached. As a result, buying pressure is created in the market from market participants before the market corrects itself again.
The three basic elements of a DCB pattern include the following:
- The stock’s price falls consistently
- The stock regains value again, but only for a short period of time.
- The stock subsequently loses value again, this time falling below its previous low point.
Trading tips for dead cat bounce
In this section, we will look at how a trader can identify, trade, and profit from a DCB pattern.
How to trade a dead cat bounce
There is not much that can be said about trading the DCB unless one is shorting a stock. For long positions, traders should wait for the bounce and then sell. If they choose to hand on to their position, they will likely incur further losses. The following are some of the tips one can use when trading a DCB pattern.
- Waiting for the rise and then selling. In this pattern, the stock will make a new low and then begin to bounce. Traders should sell after the bounce rounds over, which usually takes about one to two weeks. The worse the event declines, the quicker the bounce high appears, and the higher the price bounces.
- Short sales. Traders should look to sell shortly after the bounce rounds over. Most of the time, the stock continues lower by another 15% on average.
- Avoiding formations. Traders should avoid all bullish chart formations for at least six months to a year when trading a stock showing a DCB. If they still work, the gains they will receive are below average.
A few trading tricks for a dead-cat bounce
If a trader is caught in a dead-cat bounce, the easiest thing for him/her to do is to sell immediately.
- More seasoned traders can wait for the bounce and then sell. Traders can use an upsloping trendline to time an exit. They can simply draw it beneath the valleys as price rises and sell when the price closes below the trendline.
- More aggressive traders can short the stock once it crests during the bounce phase.
- If the trader sees a stock with a wonderful chart pattern in which a dead cat bounce happened within the last six months, he/she should avoid it.
Advantages of using Dead-Cat Bounce
The Dead-cat bounce as a pattern can provide a range of advantages such as the following.
It’s a helpful indicator
A DCB can serve as an indicator of market weakness, either within a sector or the market at large.
It’s possible to benefit from the DCB by purchasing shares when the stock hits a low point and then unloading them during the bounce.
Opportunities for short sellers
If a proper technical analysis is conducted and the stock is determined to be experiencing a DCB pattern but not a trend reversal, it can be a good time to get into a short-selling position.
The Psychology of Dead Cat Bounce
The psychology behind the DCB pattern is that initial short sellers consider that a particular stock has hit bottom, after which some of them close their short trades. There are other traders who buy the stock in an attempt to catch a reversal. Thus, this pattern provides a better short entry for sellers, who then open new short trades, causing the stock to drop in the process.
When trading this pattern, investor psychology comes into play as traders usually tend to get fearful at the same price points as they have done before. Thus, the pattern can be used to identify those price levels for potential breakouts.
- The pattern forms a gap during a downtrend when prices move between the close of one day and the open of the next. The significance of the pattern increases as the gap becomes larger. The main cause for this gap is unexpected news, which appears before or after standard market hours.
- Traders overreact to the data, which is represented by the gaps. The stock is expected to get oversold and subsequently retrace back towards the gap. The top and bottom of the gap serve as resistance barriers.
- In case the stock or market peels off of these resistance levels, it will significantly decline afterward.
As a trader, especially trading in the stock market, it advantageous to be aware of how the DCB pattern works. However, it can be tricky to identify once a trader is in the midst of it, as it is virtually indistinguishable from a stock market’s turnaround. Traders should thus resist the urge to bet high on stocks right away when faced with such a situation.