What is a Dead Cat Bounce?

Podcast Duration: 06:11

Hello friends, welcome to today’s podcast by Angel Broking.

While combing through financial news and other resources on investing and trading, you must have come across the term ‘market crash’. It refers to a rapid and dramatic decline in stock prices across multiple market segments which results in a large number of losses. Often during these crashes, the stock market exhibits fake rallies - or short periods of time where the prices of stocks rise, only to give way to further decline.

A historical example of a fake rally in a market crash is that of the Great Depression. Did you know that between late 1929 and Spring 1920, there was a rally of 47%?

Before that, the stocks had been falling as low as 45%. And after the short spike, they went on to fall 80% lower. During that period of rally, many investors gained false hope that the market might witness a changeover.

Such a short-lived increase in stock prices in a bear market before the prices continue to plummet lower, is referred to as a Dead Cat Bounce. The rationale behind the name is that after dropping so hard and at such a high speed, even a dead cat will bounce. It sounds quite morbid, doesn’t it? Well, it is a slightly morbid scenario for the market, too.

The difficult part about a dead cat bounce is that it can only be determined in hindsight.

While trading on stock markets, investors (especially short-term ones) make gains from the price movements of securities.

They use an array of technical indicators, tools and strategies to spot, study and predict the possible price movements and try to make profitable transactions. During the short-lived upward movement of prices, some investors may mistake it as a trend reversal from the price patterns. It is not their mistake as it is extremely difficult to figure out. Because only a subsequent drop in prices can confirm the dead cat bounce pattern.

To be able to understand this phenomenon, it is important to understand what leads to it.

So why do these upward movements occur, especially in an already bearish market?

When a market sees more sellers than buyers, the price of an asset continues to be on a decline for a long time. At one point, these sellers reconsider their positions. After driving down the price for a long time, some buyers start clearing their short positions by buying the stocks. A short position in this context is where a trader sells out their stock of an asset in the hopes of buying them back at a lower price in the future. After all, the market is continuously going down, so it is not an unlikely prediction.

When the price recovers slightly due to this increase in buyer activity, value investors interpret it as a sign of the price bottoming out. And they start creating long positions. Long position means that traders buy the asset hoping that it will increase in value in the future. Along with value investors, momentum investors also create long positions as all indicators now deem the asset oversold.

All of this creates a lot of buying pressure in a very short time leading to the bounce. This is also known as a false dawn.

A dead cat bounce can happen to whole markets, like the Dot-com crash where there were four false dawns before the market crashed. It can also happen to individual assets.

Say an asset which you purchased for 100 rupees went through a lot of corrections over the last few weeks, and is now trading at 25 rupees. Then the price hikes to Rupees 60 before continuing to decrease down to as low as 5 rupees. In hindsight, the increase to Rupees 60 from 25 would be deemed as a dead cat bounce.

So how can you trade during a dead cat bounce?

A bounce can happen after a decline of several weeks or even in intraday trades. The price of the security must decline at least 5% from the opening price and in case of volatile stocks, over 5% for consideration of the dead cat bounce pattern.

The best way to trade the dead cat bounce pattern is by shorting the security.

When the rally reaches the price at which the decline started, the chances of dropping again increases. One should deploy short positions only as soon as the decline starts again because that would be the confirmation of the pattern. A dead cat bounce might not form if the price continues to rise. This could lead to losses. Hence it is always best to wait for confirmation before taking positions.

Remember to use other technical indicators like candlestick patterns while looking for a false dawn. And use limit-orders and stop-losses in case the market turns up. It is almost impossible to predict an actual market bottom, even for seasoned investors, so be cautious.

As usual, happy investing!