Trading the Dead Cat Bounce

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Trading the “Dead Cat Bounce”

What is a Dead Cat Bounce

Sushi rolls, five bar patterns, and the dead cat bounce are trend reversal patterns that alert the trader to a possible change in the current trend.

A Dead Cat Bounce is a technical trading pattern that’s unique to stock, forex, and commodities bear markets whereby a swift drop is followed by a small, short-lived recovery before another brutal drop takes over.

This Pattern is largely considered an indicator of continuing market weakness.

Table of Contents

So, what causes A Dead Count Bounce in the first place?

Market sentiment, for one. For instance, take a stock that has finished lower for six weeks in a row.

At this juncture, even the most ardent bears are likely to be clearing their short positions in a bid to lock in profits.

Meanwhile, value investors might now find the stock attractively valued and start building new positions while momentum traders see oversold signals beckoning on their charts and prepare to go long.

A confluence of these factors is likely to result in significant buying pressure, albeit only briefly.

In the chart above, the Nasdaq posted several quick gains of approximately 7.8% after a long string of losses.

This happened right in the throes of the dotcom crash when the tech-heavy Nasdaq Composite was hammered very badly.

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The gains were, however, only short-lived, and the Nasdaq would go on to lose a staggering 78% of its value from March 11, 2000, through October 9, 2002.

What if It’s Just a Market Reversal?

A trader can use the dead cat bounce to initiate a short or sell position. In reality, though, spotting the dead cat bounce can be tricky business because the beginning of an upturn could be a sign of a complete trend reversal.

In the Nasdaq chart above, a complete reversal eventually arrived when the overall market sentiment turned bullish despite an apparent dead cat bounce pattern appearing at the bottom.

The Dead Cat Bounce is not confirmed when the price takes a turn higher during a downtrend, but rather when the price breaks below the previous bottom.

To do this on a Fisher Price level:

  1. Pick a stock that is going through a strong bear trend. The timeframe of the bear trend could be minutes, hours, days, weeks, etc.
  2. Identify an upturn in the price that breaks the downtrend. The bounce should be relatively minor compared to the retracement of the down move from the recent high.
  3. Wait until the price breaks below the previous low.

In the 3-minute chart of Netflix (NFLX) above, the blue lines represent a bearish downtrend that is broken by a dead cat bounce. The black horizontal lines mark a bottom just prior to it occuring.

  1. We first determine a strong bearish impulse on the NFLX chart that leads to an initial 1% drop.
  2. We observe the price breaking out in a bullish fashion
  3. The price finally reverses and breaks its last bottom.

The occurrence of these three events signals a bona fide dead cat bounce.

Trading on the Dead Cat Bounce Pattern

Timing is crucial when trading on a dead cat bounce. Once you identify one, you should short when the price action breaks below the last bottom.

Correct timing ensures that you profit as much as possible from a significant part of the price decrease. Bear in mind that dead cat reversals tend to be sharp and fast.

You should place a stop-loss order that is ideally slightly above the top of the pullback to minimize the trading risk. A simple continuation trade without a stop loss order can result in heavy losses.

With a protective stop loss order, your losses become more manageable. In the chart above/below, the upturn lasted a whole hour and riding it to completion could have landed you in a world of pain.

In practice, the magnitude of the stop loss is determined by the share price and the volatility.

For instance, a 5-cent stop loss might be all right for a fairly volatile stock with a share price of $5 or $10, but makes little sense for another stock with a share price of $200 and high volatility.

You should therefore make adjustments to your stop loss order according to these key factors.

Taking profits

Once you identify this pattern on your charts, you should expect the next dead cat bounce to be at least of a similar magnitude.

With this knowledge, your profit target for the next impulse move should be equal in size to that of the prior range as indicated in the chart below:

In general, aim for a risk/reward ratio of at least 2:1. This means that if you place your stop loss $0.50 above your entry price, the profit target should be at least $1 below the entry price.

Bringing it all together

The chart below consolidates the various procedures required to trade the dead cat bounce:

If you’re itching for more, be sure and checkout the SteadyTrade Podcast. They cover the importance of pattern recognition, and why it’s so important for stock traders.

Always remember that timing is critical when trading a dead cat bounce. You should therefore short the stock the moment you see the first candle closing below the last low of the downtrend.

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Comments

Great lesson! Please do cover more patterns in similar fashion. This one lesson made a huge difference as it’s combined with a detailed chart explaining every step.

Great lesson! Please do cover more patterns in a similar fashion. This one lesson made a huge difference as it’s combined with a detailed chart explaining every step.

Good job, thanks for the detailed info.

I am not shorting yet, only working on mastering patterns to buy on b/o and dip buying. Always enjoy the videos though.

I’m brand-new beginner and have been registered Tim Sykes since last year. I would like to have StockToTrade system completetely established to my computer and get trained as soon as possible (hopefully your price goes down a little bit so I can afford :-)). I registered Pot Stock Millionaire Summit yesterday and really want to get started with it. I’m eager to learn oyour system software and keep on studying Tim Sykes’ lessons before trading stock.
Thanks so much for your precious time and your kind patience.

Good stuff! I always watch for the DCB in pharma / biotech stocks if they have negative trial results or bad news from the FDA. Those rides can be fast and furious, tight risk mgmt needed.

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Trading a Dead Cat Bounce

By John Jagerson

Extremely volatile markets create an environment for the formation of a very specific type of technical price pattern. The “Dead Cat Bounce” pattern (DCB) may have a macabre name but it comes with very nice profit potential and is relatively easy to identify.

At its heart the DCB is a great study in investor psychology. It occurs when investors have panicked or have been caught by surprise which is why the pattern occurs most frequently in bearish and volatile markets.

[VIDEO] Dead Cat Bounce, Part 1

Investor psychology comes into play because traders are likely to become fearful at the same price levels that they have been fearful before. We use the DCB to identify those price levels for potential breakouts.

The pattern consists of a gap during a downtrend when prices have moved between the close of one day and the open of the next trading day. The larger the gap is the more significance technicians will assign to the pattern. The gap is typically created by unexpected news appearing after or before normal market hours.

The gaps indicates that traders have “overreacted” to the data, the stock is likely to become oversold at some point and will begin to retrace back towards the gap. The top and bottom of the gap will act as resistance barriers and if the market or stock peels off of these resistance levels, the subsequent decline can be quite significant.

The rally back towards the gap is a good example of a bull trap and the final decline that completes the pattern can be larges and fast as a feedback loop of stop losses push more sellers into the market.

Example of a dead-cat-bounce

In the chart above you can see a DCB that formed on Goldman Sachs (GS.) Once a breakout to the downside occurs, shorts enter the market. Buying puts at this point is a great way to limit your risk while still taking advantage of the downside potential.

In the video, I will cover the pattern in more detail with a few additional examples. In the next article in this series I will show you how you can project price targets once the pattern has completed itself.

Forecasting a Dead Cat Bounce

Identifying a dead cat bounce is just part of the challenge. Estimating or forecasting the likely distance the stock will move following the pattern’s confirmation is also important. This is a challenge for technical analysts as much as it is for fundamental analysts. Creating an estimated profit target will help you make better decisions about the trading strategy you will use to take advantage of the price move.

[VIDEO] Dead Cat Bounce, Part 2

There is a reasonably easy way to start making these estimates following the bounce back down from resistance. To do this we will be using fibonacci retracements, which are one of the primary tools used by technicians to identify support and resistance levels and to make price projections. The same technique you see in this article can be applied on many other technical patterns as well.

The image below illustrates how this analysis is conducted. A fibonacci retracement is drawn from the first bottom following the gap (point A) to the break down from resistance at the gap (point B). The retracement lines themselves can be ignored because what you are interested is past the first low at the 161.8% projection level (point C).

As you can see in the case study above this price was easily reached. Of course, ongoing trade management continues to be important but this analysis provides a solid starting point for evaluating the opportunity.

Based on the estimate you can decide how to best take advantage of the opportunity. A very tight profit target may be difficult to trade with a long option and a short call sold above resistance may be more attractive. Conversely a very long profit target could be ideal for a long option that retains unlimited profit potential.

Trading a technical price pattern is a three step process. First we identify the pattern and wait for confirmation. Second, the an initial price target estimate is produced. Third, using the information gathered in the first two steps you can select the right trade strategy and actively manage the position. Approaching an opportunity this way helps traders maximize a profit opportunity.

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Trading the “Dead Cat Bounce”

One of the best short trades in the world is the “dead cat bounce.” It is called so because even though the market may bounce after a devastating fall, it isn’t going to moving significantly higher anytime soon. The bounce is dead and those that go long expecting the price to rally further are also dead; it’s a sucker’s bet. Here’s what the dead cat bounce is, how to avoid getting trapped by it, and how to capitalize on it.

The Dead Cat Bounce

The dead cat bounce is when the price of a stock gaps down dramatically, typically 10% (or close to it) or more from the prior close. A gap of this magnitude is usually caused by earnings or news which came out after the prior closing bell.

The gap is caused by massive selling during the pre-market and at the open. Yet once the stock begins trading it attracts novice traders and investors who now view the stock as a bargain. Usually not too long after the open these people will jump in and buy the stock up. The buying will typically dies out by the time the stock reaches the open price, or slightly above.

Where the stock opens is likely to be a major resistance area, so when the price nears that area professional traders are looking for shorting opportunities. When the price enters the resistance area professionals step in to short any further rallies, and the novice traders and investors who just bought realize their mistake–this stock just dropped 10% and is not a stock many others want to own right now. With even the short-term buyers bailing on the long trade, the stock quickly sinks, often to a new low for the day.

Figure 1 shows a dead cat bounce in Pier 1 Imports (NYSE:PIR)

Before the market opens the stock is already trading significantly lower (light grey area). When the market opens (black area) the price drops at first but then rallies higher, moving above the open price, but stays below the high of the pre-market session. Between the open and the high of the pre-market session marks a major resistance area where price is likely to stall out, and experienced traders are waiting to jump on the short, expecting the selling to continue.

Even Dead Cats Have Two or Three Lives

After a significant gap down the price will often rally to the open price, or just above or below it, within a short period of time–minutes–and then fall again. Since this is right near the open the price action can be erratic, and trade signals may be disguised in a whole bunch of noise and big price bars.

This level will often get tested one or two more times though. Sometimes it occurs in the same day, and sometimes it occurs several days later. These re-tests are usually less volatile, and therefore the trades are easier to spot.

Figure 2 shows the same chart, but this time with the resistance marked by horizontal red lines. The price moves into the resistance zone 3 times. The second and third times there is less volatility, and the bars are quite small, so we can see the shift in momentum back to the downside more clearly.

Trading the Dead Cat Bounce

For the most part I recommend most traders–unless you are experienced– skip the first bounce. While this can be the most lucrative and fast moving, given the potentially erratic nature of the price near the open (following news) a trade signal may be hard to isolate.

Trade it though, if you feel so inclined using the following method.

  • Wait for the price to enter into the resistance region.
  • Go short when down movement completely erases the progress of the latest green/up bar. This can occur inside or just below the resistance zone, if the price has already fallen below the zone after being in it.

Figure 3 shows the price bars you would have gone short on. For number 2 we have a rise of all green bars which move into the resistance zone. We then have a strong red bar which moves below the low of the last green candle. The green candle also had a long tail on the top, which indicated selling pressure. This followed by a strong red bar was a sell signal. Sell short (buy puts) when the price moves below the low of the green candle (this would have been right near the horizontal red line).

For number 3 the price rallies into the resistance zone, and at first each bar is moving higher (higher lows). Two red bars occur in succession and second red bar moves below the low of the green bar. It took two red bars to take out the low of the green bar, but the overall message was that the price is heading lower and you need to get short (right near small grey horizontal line).

If trading binary options, look to exit these trades fairly quickly. If trading on a one minute chart, trades can last 1 to 5 minutes. This should provide enough time for the price to move into the money.

If trading the actual stock you will want to hold longer, as the expectation is that the price will continue to drop, potentially significantly, which will increase your profit on your trade if the drop materializes. In this case the price eventually fell well below $16.

Final Word

If a stock drops 10% (close to it, or more) overnight, don’t go bargain hunting. Instead, wait for a rally and get ready to snack it short when the price enters the resistance zone and begins to falter. If trading binaries, look to get out fairly quickly. If trading the actual stock the goal is to have a short position when the next major wave of selling occurs. Sometimes the price will test the resistance zone near the open a couple times on the day of the gap, and something it will only test it once. If the stock continues to fall, watch for the price to re-test the resistance zone several days later; if that occurs the same tactics can be used again.

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