Dead Cat Bounce – How to Spot and Trade It?
Stock markets run high on volatility amidst high/low cycles or what is popularly known as bear and bull markets. Many factors, including economic, political, technological, legal, industrial and company-specific, drive the volatility of these markets.
Among the various indicators that predict the price movement in stock markets, one of the surest signs of a bearish market is when there’s a dead cat bounce.
Read on to find out more about this topic in detail!
What is a Dead Cat Bounce?
This phenomenon occurs when an asset’s price suddenly rises during a continued decline. However, this rise is short-lived, and the downtrend soon resumes. A dead cat bounce pattern, at first, may be viewed as a reversal of the current trend but is swiftly followed by a continuation of the downward price movement, which, in technical analysis, is regarded as a continuation pattern.
A dead cat bounce pattern might present a very lucrative trading setup. However, it is also a risky pattern because it frequently deceives new traders into believing that a bullish reversal is happening. This is why it’s crucial for new traders to become familiar with the setup and develop their ability to spot dead cat bounces in real-time market conditions. It is to be noted, however, that a dead cat bounce pattern is typically difficult to spot in real-time and only becomes apparent after the event.
What Does a Dead Cat Bounce Indicate?
To determine if a stock—or any other asset—that appreciates following a protracted drop will continue to increase, one must look for signs of a dead cat bounce.
For instance, if a trader thinks a price increase is a dead cat bounce, he or she may decide to keep the short position open. On the other side, if a trader thinks a price movement is long-term and sustainable, they may try to cut their short position.
To put it another way, it is crucial to comprehend this phenomenon in order to make the best trade decisions.
It is not a good idea to try to use the dead cat bounce phenomena as a shortcut to profitable trading. In general, understanding a company’s fundamentals is a better way to produce market-beating returns.
It might also be useful to think about whether a stock with a low price is gaining momentum and interest because the company’s operations are improving or if it is doing so merely because it seems inexpensive after a protracted downturn.
Also Read: Swing Trading – Strategies, Setups, List & Pros and Cons
What Causes a Dead Cat Bounce?
The drivers behind the dead cat bounce may vary widely. A dead cat bounce can be caused by short-covering (short-sellers exiting trades), a response to a data release or event, technical factors, and more.
For instance, a stock that has been facing continual decline may suddenly declare robust results. Now, this may push the stock up, but it should mostly be a short-term phenomenon or a short-lived rise.
How to Spot a Dead Cat Bounce?
Investors must be aware of the possibility of a dead cat bounce while trading to avoid losses. All said, it can be challenging to spot the DCB. Given below are some early signs of a dead cat bounce to watch out for:
1. A brief rally: This event typically results in a temporary increase in the security price before it begins to decline again.
2. Low volume: Low volume during the rally is another indication. This can be due to low buying interest to support the price increase.
3. A lower high: Although the price has increased, it hasn’t increased as much as it did during the previous peak. This may be a bearish sign that the downward trend is still ongoing.
When an investor notices these signs, it is usually a good idea to avoid being caught off guard. These bounces can present opportunities, but remember, they are not long-lasting trends. Investors who are unfamiliar with these should likely exercise even greater caution when these signs appear.
Example of a Dead Cat Bounce Stock
One of the prominent examples of a dead cat stock is – Cisco Systems, where the stock prices reached their all-time high of $82 per share in March 2000 before dropping to $15.81 in March 2001 due to the dot-com crash.
In the following years, Cisco witnessed numerous dead cat bounces. By November 2001, the stock had recovered to $20.44, only for it to drop to $10.48 by September 2002. In June 2016, Cisco traded at $28.47 per share, less than one-third of its 2000 peak price during the tech bubble.
How to Trade a Dead Cat Bounce?
A simple understanding of the market structure can aid in trading dead cat bounces. Resistance and support levels, for instance, can be extremely useful to trade DCBs as it helps one identify the resistance level and then fade the bounce as the price approaches the resistance level.
Besides resistance and support levels, several options are available for trading in such a scenario. More aggressive traders can just choose to trade the level strike, taking a short position as the price approaches the marked resistance level.
Whereas more cautious traders can hold off until price action confirmation. As a result, in this case, they would watch for candles that signal a price reversal, such as bearish pin bars or bearish engulfing candles, to form. They would then enter a short position as the price reverses lower from these candles.
Technical Indicators for a Dead Cat Bounce
The Stochastics indicator is one of the best technical indicators for DCB. Under this method, one needs to wait for the Stochastics indicator to cross the overbought line, indicating that bullish momentum is stretched to the top and susceptible to a bearish reversal.
Determining that momentum is turning lower and price is starting to reverse requires waiting for the indicator to cross back under the overbought threshold.
When employing this strategy, one can either rely solely on the indicator reading or try to combine it with another strategy, such as support and resistance.
In this scenario, one can watch for the price to trade back up and test a resistance level before looking at the indicator to provide an entry.
This is an effective yet straightforward technique to create a dual-criteria trading method, whereby one would enter the trade only when both indications work as follows —price-hitting resistance and the Stochastics reaching overbought territory.
Limitations while Identifying a Dead Cat Bounce
A dead cat bounce is typically only discovered after the event occurs. As a result, traders who see a rebound following a sharp collapse can mistake it for a dead cat bounce when, in fact, it is a trend reversal indicating a prolonged upswing. It is therefore tough to tell if the rising trend that is being seen is a dead cat bounce or a market reversal. The truth is that there is no simple answer to know.
The truth is that identifying market movements is not easy, and it can be almost impossible to judge DCBs given the volatility of the market.
Also Read: Stock Market Index – Importance, Need, Types & Selection
Final Word
A dead cat bounce is a phenomenon wherein a stock’s sudden rise is dismissed with a continued fall. Here, investors might believe that the security is recovering and about to start rising again, which would be a false hope. Because of this, it’s critical to be alert to the warning indications.
Even in the best of circumstances, knowing the difference between a bottom and a dead cat bounce is crucial for traders. Although there are no easy ways out, knowing and understanding the dead cat bounce can be a step in the right direction.
FAQs on Dead Cat Bounce
Ans. Dead cat bounce refers to a phenomenon that occurs when an asset’s price suddenly rises during a continued decline. However, it reverses soon after as the boom is short-lived.
Ans. The Stochastics indicator is one of the best technical indicators for DCB. Resistance and support levels can also be employed.
Ans. A dead cat bounce can be caused by short-sellers exiting trades), a release or event, technical factors, etc.
Ans. It may not be easy to spot a DCB. However, with technical indicators and tools, one can attempt to spot a DCB.
Ans. Yes, many traders constantly trade DCBs. But remember, this can be extremely risky and is best employed with caution.
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
