What is Dead Cat Bounce?

Sounds Macabre. But, Dead Cat Bounce has something to do with the stock market. What would a dead cat bouncing have to do with the market?

It’s a metaphor that has been around since the 80’s and believe it or not it came from the Singapore and Malaysian traders.  So what does dead cat bounce stand for?

A dead cat bounce is when the price of a plummeting stock shows a little rise. So if a stock has been consistently going down and the price increases for a bit, it’s called a dead cat bounce.

The idea is, when a dead cat is thrown from a tall building, it hits the floor and bounces back up for a bit for a brief period of time. However, heartless that sounds, that is the theory behind the phrase.

So what is the actual stock phenomenon?

A dead cat bounce happens when traders generally are closing their short position or buying the stock when they think the stock has reached it’s lowest. The dead cat bounce is common among technical analysts. For a dead cat bounce to happen, the price of stock should be falling and then show a slight resurgence before going down again.

A dead cat bounce is a good trader ploy, because it gives them an opportunity to purchase the stock at a low price and the value of their holdings go up during that small resurgent phase, when they sell again.

Although it’s extremely lucrative for traders, it is very hard for investors to predict a dead cat bounce. Also, a dead cat bounce’s resurgence could last for months before it falls.

Why is it important?

As the stock market is very emotion driven, a dead cat bounce may seem like the fortunes are turning when in reality it’s going to go down further. Having an idea of this phenomenon and trading habits of traders will help retail and individual investors to fight the urge to pump in money when the stock prices are rising.

So if you are a retail investor and you see the price of a stock declining, and when you see a small resurgence, try to keep your emotions in check and analyze the market and the stock before you put your money in the stock.

Examples of a dead cat bounce

Here is an example of a dead cat bounce in action. This is from Tradingsystemforex.com

what is dead cat bounce

Here is an actual stock graph with dead cat bounce in action. As you can see on the chart, there are multiple factors to a dead cat bounce. The price of the stock has been consistently dropping from 70 and plummets to the 30 level.  After that it hits 20 and bounces back to 35. A resurgence of sorts. There are other upward spikes in the charts, but nothing as much as the one that is pointed as a dead cat bounce. And look at the bar chart at the bottom and look at the volume levels. There is a huge spike in the number of trades done for this stock.

How to trade a dead cat bounce

Trading a dead cat bounce can be extremely tricky and you can incur huge losses if you do not follow protocol. Here are some tips on trading a dead cat bounce.

Firstly you need to spot a dead cat bounce and implement some strategies.

  • Identifying a declining or bearish stock

Firstly to identify a dead cat bounce, you need to find a stock that is dropping rapidly. If the stock is in a consistent bearish trend, then you are likely seeing the first step of identifying a dead cat bounce.

  • A sudden price increase

Identify a price increase that breaks the previous trend of continuous falling,

  • Pause and Wait

Wait on the price so that you break the last bottom that has been created.

The next few steps involve, trading the actual dead cat bounce.

  • Start your trade when the price goes below its previous low.
  • Register your stop loss above the top of the sudden price increase I mentioned earlier
  • Stay in the market until the price goes back to a similar bearish situation.

The dead cat bounce can be an extremely tricky trade to pull off and you need to be a seasoned trader with all the tools and analysis to pull one off with aplomb. This article is to educate the user on such a phenomenon and not direct advice on how to trade a dead cat bounce.