Millions of traders buy and sell securities every minute. The volatility in the market is the result of continuous buying and selling. One of the most important tasks of a trader is to find patterns and make sense of market movements. The identification of clear patterns helps traders and investors in deciding the course of action. Some patterns are a sign of continuity while others signal towards a trend reversal. Many traders, especially short-term investors operate on the basis of these patterns. The dead cat bounce is a popular pattern in the investing community. The rationale behind the dead cat bounce pattern is very simple which makes it easy to understand. Even though the dead cat bounce pattern is simple in theory, it is hard to identify in real-life situations.
What is dead cat bounce?
The dead cat bounce is a continuation pattern that is formed after a prolonged decline in prices. In most instances, there is a short recovery in prices after a long period of decline. Many market participants assume the recovery to be a sign of reversal. However, the recovery is short-lived and prices start falling again after a brief interval. Once the price starts declining again after the recovery, it goes below the previous lows. The pattern formed by the short recovery and continued decline is known as the dead cat bounce. The rationale behind the name of the pattern is that even a dead cat will bounce if it witnesses a steep fall for a long time.
What causes a dead cat bounce pattern?
To understand the reason behind a dead cat bounce pattern, it is important to know the dead cat bounce definition properly. A dead cat bounce is a pattern primarily used by technical analysts. To identify a dead cat bounce, traders and analysts have to determine with adequate certainty if a rally after a long decline is short-lived or permanent. The question arises what causes a dead cat bounce? When bears become dominant in the market, the price of an asset declines continuously for a long time. However, there comes a time when even bears reconsider their positions. After driving down the price for a long time, some bearish traders start clearing their short positions and book partial profits. As the price recovers slightly, value investors read it as a sign of bottoming out of the price and start creating long positions. Along with value investors, momentum investors too create long positions as all indicators point towards the oversold territory. Together, all these create a buying pressure for a short time leading to a dead cat bounce pattern.
How to trade a dead cat bounce pattern?
A dead cat bounce is hard to predict even for seasoned investors. A dead cat bounce can happen after a decline of several weeks or even in intraday trades. The price of the security should decline at least 5% from the opening price. In the case of volatile stocks, the fall must be over 5% to consider for a dead cat bounce pattern. The best way to trade the dead cat bounce pattern is by shorting the security. In the case of a dead cat bounce pattern, the price will decline steeply and then will witness a short rally. When the price reaches the opening level or the level from where the decline started, then the chances of falling again increases. After touching the opening levels, the price will start declining and one should create short positions as soon as the fall starts. It is advisable to short the security only after the price starts falling again as it is a clear signal of a dead cat bounce pattern. A dead cat bounce may not form if the price continues to rise, which could lead to losses and hence it is better to confirm the pattern before taking positions.
Just like other technical patterns, one should act only after taking other indicators into consideration. It is important to be careful while acting on dead cat bounce as it is identified only in hindsight. Set price targets and use stop loss to limit the losses due to a misread dead cat bounce pattern.