What goes down must also come up. This is a less-discussed but equally true phenomenon. Sometimes, at least.
It may sound alarming to hear the term “dead-cat bounce”, but if you only hear it in relation to trading, then it is referring to a specific phenomenon on the stock market.
This phrase is derived from the idea of dead cats bouncing back if they drop from a height high enough. The asset price may temporarily recover when it drops from a high level, even though it is “dead”.
Why should you be concerned? You can make money by using backtested trading strategies.
Stock Market Chart
Table of Contents
What is Dead Cat Bounce (DCB)?
What are the causes?
The Economics at Play
Market Psychology
Real-World examples
Reversal or Bounce:
Dead Cat Bounce Strategy
Bottom Line
What is Dead Cat Bounce (DCB)?
Media often discuss asset prices in a way that implies they are either going up or down. Investors and traders know this is not the whole picture.
It is rare for a stock to fall straight down, without experiencing some peaks. The dead cat bounce is an extreme example: when the stock price drops, it can seem to recover slightly before returning to the previous low.
Early in 2020, the stock market experienced a sharp and rapid decline. It was only a rebound that prevented a nearly vertical line downward.
Dead Cart Bounce Example Stock Chart
Let’s see what happens when a stock starts to lose value.
Few buyers are willing to make an investment. Most investors will panic. They’ll pull out their money. Some traders will short trade. We’re still likely to be panicked, even if we do nothing. The human brain is designed to react emotionally.
If we think rationally, it is unlikely that the price will continue to drop indefinitely. The panic will eventually subside and the price of the stock will begin to rise again. If traders and investors are smart, they can take action.
Many traders will mistakenly think that this small blip is a real recovery. You probably only have one question at this point: Why does this happen?
What are the causes?
Pessimism can turn into a bearish market, causing a bounce. When the market continues to show a downward trend, it creates the conditions for a rebound.
Short selling is a strategy that bears use to try and profit from the continued decline of prices.
Value investors, who look for stocks that are undervalued, may purchase the stock if they think it will increase in value.
The traders who are shorting will eventually want to cover their short positions and cash out. So they switch from being sellers to becoming buyers, adding value to the investors’ purchases.
This activity leads to a temporary rise in demand, despite the fact that the stock is “dead”.
Markets are dominated by the tension between bullish versus bearish opinions, and whether or not they believe that the market has already fallen too far and too quickly, or if it still has a lot of ground to fall.
The Economics at Play
You’re likely aware that supply and demand are the two major forces in economics.
Investors who short the stock are the ones driving demand in the event of a bounce. They believe that the price of the stock is going to rise.
The price is dropping because the traders are selling more than they can buy.
When people want to buy and believe that the price is too low, the demand curve will temporarily shift outward, increasing the cost — but soon it will move back in.
This is a very simplified view of a complex situation.
Market Psychology
The path to profiting from bounces is clear in retrospect. Why do traders lose money instead of making profit?
They’re partially blinded by the short-term movements, (the bounce), and aren’t aware of the larger trends.
Greedy investors don’t like to congratulate themselves and quit when the stock they bought at the bottom of the market increases by 10% or even 20%. They hold on to the stock for too long, and they end up losing money.
Fearful traders will also panic when they see the price of one of their investments dropping, even if there is a rebound due.
Traders who lack impulse control due to greed or fear are doomed to failure. Accept that you won’t time the market perfectly. (Design a strategy to reflect this). And that’s okay.
It is for this reason that I have invested a lot of time and money in improving my trading psychology. This has greatly improved my decision making during these critical moments.
Real-World examples
It’s all very well to talk in theory, but you need to be able recognize patterns to know how to trade.
Here are three examples of how you cannot understand the future without understanding the past.
The case studies I have shown all deal with larger trends which took place over a period of weeks or months. However, dead cat bounces are also possible to occur within a matter of days — like the crash in 2020 that I showed earlier. It’s impossible to predict when a bounce is going to start or finish.
The Great Depression
The Great Depression is a period in financial history that is referred to more than any other.
We tend to see it as a time of sharp and sustained declines. We can forget the past because it was not so simple at the time.
After the 1929 crash, stock prices rose by 47% from late 1929 to spring 1930 — a near-complete recovery.
You can guess that prices began to plummet with a vengeance. They dropped by 80% in a short time.
The Depression included many mini-rallys and bounces on the way.
The S&P 500 of 1974
It’s not surprising that you can find bounces as early as 1929, although nothing is as dramatic.
In November 1974 the S&P 500 plunged, recovered 17% and then fell back to its old low.
The NASDAQ in 2000
In 2000, the NASDAQ experienced a similar situation. The index fell 27% between September 1, and October 17, before recovering unexpectedly by 9%.
At the time, other indexes displayed patterns similar to those of the FTSE 100 Index. However, they were not as pronounced.
Here are just three of many. If you think back to any examples where a stock’s price has dropped (or risen), there is a good possibility that it had experienced a brief bounce before.
Reversal or Bounce:
After seeing the three examples of history, it’s easy for us to assume that a period of sustained decline will result in a rebound. Don’t be too confident. There are times when there is a complete turnaround and upward trend.
It is difficult to tell the difference between an upswing and a downswing. I wish I had a foolproof way of doing it. I’m afraid that there is no way to do it other than to recommend you use your understanding of the fundamentals of the market and your own trading style and psychological makeup.
Here are a few rules to follow.
Wait until the value increases, and then watch for further signs of a bounce.
A reversal pattern or bearish pattern, such as a double-top that fails, is one telltale sign. You can now proceed to a short trade with less risk.
You could also wait until the price falls below the support level (previous dips or rises prior to the significant increase).
You’re ultimately looking for signs that the forces of supply and demand are changing.
How to hedge yourself
Opening a short position after stock prices have fallen dramatically and then started to rise again can be an appealing prospect.
It’s important to not misinterpret the bounce and put more capital at risk than planned.
You can “test” the market by waiting for it to return to its low. If you’ve waited a few days and the price is comfortably above its previous low, this could be a sign of a real recovery.
Expect to see an imperfect “W”-shaped recovery, where prices consistently drop and then rise again.
If this occurs, I suggest setting a stop-loss just below the V to allow you to exit the trade if the price collapses (more about risk and stop losses later).
You’ll be interested in the next part: perfecting your strategies.
Dead Cat Bounce Strategy
You now have a solid understanding of dead cat bounces. Let’s move on to the most important question: How can you successfully trade a dead-cat bounce?
First, you should be aware that each dead cat bounce will differ slightly. So don’t expect the same example every time. You cannot assume that the market has bounced just because there was a dip, followed by an upward trend. This could mean anything.
Let’s now move on to the strategy. There are a lot of different ways to go about this, and you could ask a hundred traders. But I would recommend using the bounce as a way to enter a long.
Trading when you think the price is about to fall, as opposed to when you think it will rise, is generally safer.
Use the above methods to help you distinguish between a bounce (which is good news for those who are short) and a recovery.
Wait for the price of the W formation to reach its maximum.
A price that extends during closing, or approaches the opening price is a sign. Another is panic buying.
Do not short the rebound by following the downward trend. It’s easy to get caught by this strategy. You might expect the prices to continue to drop, but it is not a good one. Wait until the lowest point has been reached.
Stop placements and targets
Stop losses and price targets will help you navigate the market effectively.
Set the price target for your short position higher than the previous low. When the price starts to rise again, you can exit. Do the opposite when shorting. Set a stop loss just above the high of recent trading.
To avoid being caught off guard, you should try to place your stop orders and price targets at a distance from the normal range of fluctuations.
Bottom Line
It is not easy to trade a dead-cat bounce. This is a risky strategy that requires some practice and a good understanding of asset prices.
It’s a strategy that every investor or trader should add to their arsenal.
This article was originally published on Wealth of Geeks. It has been republished by permission.
