The dead-cat-bounce trader watches the price fall; when it starts to bounce, they get ready to go short. A bounce is a second chance for scared investors to unload shares, which will push the stock price lower and create an opportunity for short-selling day traders. What Is a Dead Cat Bounce? In the simplest terms, a dead cat bounce is a sharp decline, followed by a failed rally and further decline.
Like with all charting patterns, the exact parameters of a dead cat bounce are somewhat up for interpretation. However, there are four general features to look for as you learn how to best define a dead cat bounce for yourself. Gap Down For a dead cat bounce to occur, a stock must gap lower i. Sustained Decline The price must continue to decline for at least five minutes after the opening bell—preferably longer. As with the gap percentage, five minutes is just a guide. The point is that the price needs to continue falling after the open.
If it doesn't keep falling after the gap down, then it isn't a dead cat bounce, and you shouldn't try dead-cat-bounce trading strategies on it. The Dead Cat Bounce After the sustained decline, the namesake bounce starts to occur. A stock should get close to the initial gap-down opening price. The price might not hit the opening price perfectly, so traders must remain flexible and study the price movement carefully.
Decline Resumes After the dead cat bounce, the price plummets again. At that point, the dead cat bounce has completed its pattern, and traders will watch for the best exit points. Shorting a Dead Cat Bounce The gap-downs that start a dead cat bounce are usually due to fundamental news that came out overnight, such as an earnings release.
The dead-cat-bounce trader watches the price fall, and when it starts to bounce, they get ready to go short. Why short? Because "the cat is still dead. Significant damage was done to the stock price, the underlying issues with the company are still there, and investors are still scared.
A bounce is a second chance for those scared investors to unload shares, which will push the stock price lower and create an opportunity for short-selling day traders. Watch for the price to rally back into the vicinity of the opening price.
Remember, the area around the opening price is likely to be a resistance level, but that is just a guide. You want the price to come close to the opening price, but it might stay below or go just above. The final player to enter the picture is the momentum investor, who looks at their indicators and finds oversold readings. All these factors contribute to an awakening of buying pressure, if only for a brief time, which sends the market up.
Dead Cat or Market Reversal? As we noted earlier, after a long sustained decline, the market can either undergo a bounce, which is short-lived or enter a new phase in its cycle, in which case the general direction of the market undergoes a sustained reversal as a result of changes in market perceptions. This image illustrates an example of when the overall sentiment of the market changed, and the dominant outlook became bullish again.
If this could be answered correctly all the time, investors would be able to make a lot of money. The fact is that there is no simple answer to spotting a market bottom. It is crucial to understand that a dead cat bounce can affect investors in very different ways, depending on their investment style. It's critical to understand market fundamentals to determine if an uptick in the market is a dead cat bounce or a market reversal before making further investment decisions.
Style and Bouncing A dead cat bounce is not necessarily a bad thing; it really depends on your perspective. For example, you won't hear any complaints from day traders , who look at the market from minute to minute and love volatility. Given their investment style, a dead cat bounce can be a great money-making opportunity for these traders.
But this style of trading takes a great deal of dedication, skill in reacting to short-term movements, and risk tolerance. At the other end of the spectrum, long-term investors may become sick to their stomachs when they bear more losses just after they thought the worst was finally over.
If you are a long-term, buy-and-hold investor, following two principles of investment diversity and long-term horizons should provide some solace. Finding Solace A well- diversified portfolio can offer some protection against the severity of losses in any one asset class. For example, if you allocate some of your portfolios to bonds, you are ensuring that a portion of your invested assets is working independently from the movements of the stock market.
This means your entire portfolio's worth won't fluctuate wildly like a torturous yo-yo with short-term ups and downs. A long-term time horizon should calm the fears of those invested in stocks, making the short-term bouncing cats less of a factor. The Bottom Line Downward markets aren't fun at the best of times, and when the market toys with your emotions by teasing you with short-lived gains after huge losses, you can feel pushed to the limit.
If you are a trader, the key is to figure out the difference between a dead cat bounce and a bottom. If you are a long-term investor, the key is to diversify your portfolio and think long term.
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