What is a dead cat bounce?

Posted on Wednesday, May 22nd, 2019 MarketBeat Staff

Summary - In December of 2018, investors saw the crushing effect of volatility. In one month, in fact, it only took about a week of trading days, the S&P 500 Index gave up all its gains for the entire year. Investors were rattled and in the first few months of trading in 2019, traders got glimmers of hope only to see the market fail to recapture its previous highs. Many investors are concerned that the rally that started in January may not be the reversal of a trend, but a brief pause before a more prolonged downturn.

The condition where an individual stock or, in this case, an entire index posts a gain after a sharp decline but then continues on a downtrend is a technical trading pattern known as a dead cat bounce. A dead cat bounce is unique to stocks, commodities, and foreign exchange (forex) trades. No industry is immune to such a pattern, although some industries (such as technology and biotech) are more prone to them. Increased volatility and high volume are frequent indicators of sectors that experience dead cat bounces.

Although day traders can look for dead cat bounces over very short time periods, they are frequently part of a pattern that manifests itself over weeks or even months of trading. For example, it may take an asset several trading days to reach an initial bottom and the bounce that follows may run for weeks or even months. In general, traders can expect that the steeper the decline in an asset, the steeper and perhaps more sustained the bounce. However, for there to be a dead cat bounce, the trend will always be bearish. Dead-cap bounces do not occur in an uptrend.

One of the reasons dead cat bounces put fear in the hearts of investors is that they are difficult to predict until after they have occurred. For example, several investors called for a reversal in the market in 2009 only to be caught off-guard by the market’s historic bull run.

Introduction

Timing the market is a difficult investing strategy under the best of conditions. Many investors have been burned by buying a stock that started to increase in price after a big decline only to see the rally lose momentum as the price quickly reverses and the stock price falls even further. This was the fate of many dot-com stocks in the early 2000s. But it was also prevalent in the 1980s, a time when they made a movie called Wall Street and the stock market took on renewed interest, becoming accessible to a broader range of investors. During this time, investors in the United Kingdom coined the phrase “dead cat bounce” referring to a time when an asset begins to rise in price after a long correction only to fall again.

In this article, we’ll dive deeply into what a dead cat bounce is and what it means to investors. We’ll look at some key terms that help understand the trading pattern that leads to a dead cat bounce. And because a dead cat bounce is often difficult to detect while it is happening, this article will provide some technical indicators that help traders understand the conditions that typically set up a dead cat bounce and some basic trading strategies that can help ensure profitable trades in both long and short positions.

What is a dead cat bounce?

A dead cat bounce is an event that takes place as part of a prolonged price downtrend. After a gap where the price of an asset falls significantly from its previous high, the price may appear to recover or signify a trend reversal. However, this price movement is short-lived and the price will continue to decline, typically moving past its prior low. The origin of the term "dead cat bounce” is based on the idea that even a dead cat would bounce if it falls far enough and fast enough.

What is the significance of a dead cat bounce?

A dead cat bounce is known as a continuation pattern because although the bounce may initially appear to signal a trend reversal it is followed by a continuation of the downtrend. From a technical analysis standpoint, a dead cat bounce is called when the price drops below its prior low (or trend low). A dead cat bounce creates opportunities for traders to take long or short positions.

However, a dead cat bounce is nearly impossible to predict prior to it occurring. In this way, investors looking to profit from a dead cat bounce will need to use other fundamental and technical indicators to help predict whether or not the bounce is temporary.

How long can a dead cat bounce last?

In some ways, the answer to this question depends on the trading timeline. Day traders, for example, are looking for bounces that are as short as an hour. However, historically dead cat bounces are measured over a period of weeks or months. For example, the period from the initial event decline to the final trend low can take place in a single trading day or it can take a week. Volume and volatility will play key roles in both the severity and the duration of a dead cat bounce.

Terms to help understand dead cat bounce

  • Event decline – this defines the initial decline in the price of an asset that precedes the dead-cat drop. This decline will typically be between 15-70% over the course of a trading day.

  • Trend low – this is the final low that an asset will reach before the dead cat bounce. In some cases, it can take several days from the initial event decline to the time that the price reaches the trend low.

What technical indicators must be met to identify a dead cat bounce?

A dead cat bounce is regarded as a trailing signal, meaning that it cannot be accurately identified until after it has occurred. However, there are five accepted technical signals of a dead cat bounce.

  1. The price gaps downward, typically between 15-70%.This is known as the event decline. In about half the cases, this decline will mark the trend low. However, in other cases, it is only the first leg.
  2. The price will continue to gap down the next day. As we noted above, in about half the cases, the initial decline will bring the price down to its trend low. However, the rest of the time, the price will continue lower the next trading day. And it doesn’t end there. Seventeen percent continue the trend into a third day; nine percent into a fourth day, and three percent into a fifth day. The average time between the beginning of an event decline and the price reaching a trend low is seven days. The average price decline between the initial price gap and the trend low is 31%.
  3. Once the trend low is hit, the price will start to rise. This is the dead cat bounce. From the time of the initial bounce to the peak of the bounce may take as long as six months. This is an important characteristic of dead cat bounces. While the price decline will occur over a relatively short span of time, the bounce could take significantly longer. This is one reason why it can be difficult to identify a dead cat bounce until after one has occurred.
  4. When the bounce reaches its peak, the price will continue to go back down. During this new plunge, the price may decline approximately 30%, putting the price an average of 18% below the event low 60% of the time.
  5. There will possibly be a second dead cat bounce.In some cases, about a quarter of the time, there will be a second dead cat bounce within three months that could rise as high as 15%. Nearly 40% will have a second dead cat bounce within six months.

Trading tactics to profit from a dead cat bounce

Trying to trade a dead-cat bounce is a risky investment strategy. One of the reasons for this is that when investors are selling an asset, it is often driven on short term market sentiment which can increase the probability that traders will suffer a loss. However, a dead cat bounce can provide traders with a lot of trading opportunities regardless of which side of the trade that they are on.

  1. Buying on the bounce– For traders looking to take a long position based on a dead cat bounce, they should take care to watch how far the price is falling on the day of the event decline. In general, the larger the drop, the greater the potential for a large, lengthy bounce.
  2. Sell on the bounce– For investors who already own the stock, they should wait for the bounce to peak and then sell.
  3. Executing a swing trade– This is a strategy where traders buy a stock when it is near the trend low and ride it until the dead cat bounce reaches its peak. This strategy requires a significant initial decline (e.g. 30% or more).
  4. Shorting the stock– For traders looking to take a short position, they can short the stock at the top of the bounce and hold on to the stock as the price moves lower. In general, traders should expect the stock to drop to at least the level of the trend low.

Are certain industries/sectors more prone to dead cat bounces?

A dead cat bounce can affect any stock. Even popular growth stocks, such as Amazon, have shown the ability to have a dead cat bounce. However, if an industry or sector is more prone to a dead cat bounce it can become more risky for investors. Volatility would be one indicator of an industry likely to experience dead cat bounces. In general, a stock that is prone to aggressive growth, such as biotech, is typically more prone to dead cat bounces. Utility stocks, by contrast, are less likely to experience a dead cat bounce. The other side of that coin, however, is that utility stocks are not known for their high growth. Dead cat bounces are also common with commodities such as crude oil which has been known to have brief “correction” periods even when the overall trend is bearish.

The last word on dead cat bounce

A dead cat bounce is called a continuation pattern because while, at first glance, it may seem to signal the reversal of a downtrend, it is only a brief head fake before the asset will continue its downward trend. A dead cat bounce is unique to stocks, commodities, and foreign exchange (forex) markets.  Dead cat bounces are only present when a particular asset or index within these asset classes is in a bear market, or downtrend.

A dead cat bounce is a trailing indicator for investors because the future is hard to predict. For that reason, a dead cat bounce can be difficult, if not impossible, to identify before it has occurred. Day traders who look for patterns over a very brief time period may set parameters that provide an opportunity to trade what can appear to be a dead cat bounce. In reality, it may take several trading days of a price decline for a dead cat bounce to begin. And once the bounce has started, it may last several days or even weeks and months before reversing. For traders looking to profit from a dead cat bounce, a rule of thumb is that the larger the initial decline (i.e. the deeper the trend low), the higher the bounce and the longer it will last.

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