Dead cat bounce: what is it and how do I trade it?
When markets are in free fall, the term dead cat bounce starts to emerge. What does this mean, and how is it possible to profit from such a market phenomenon?
Dead cat bounce explained
‘Dead cat bounce’ is a term used when a market manages to muster a rebound within a prolonged period of downside. The market notion behind the phrase is that if something falls with enough speed, even a dead cat would bounce. However, while such a rebound invariably happens, the trend is then expected to kick in, bringing the bearish influence back into play. A dead cat bounce can occur in any market, yet is a particularly prevalent phrase in equity markets.
Markets do not move in straight lines and, while we could see a market seemingly in freefall, some form of retracement is always likely to be around the corner as profit taking and buy-the-dip merchants come into play.
How to spot a dead cat bounce
To a large extent a dead cat bounce is a retracement, in comparison to a reversal. This means the rebound is temporary. Coming in the midst of a sharp period of weakness, the existence of an established directional bias should help traders spot a dead cat bounce. The utilisation of both fundamental and technical analysis can help traders understand whether we are set for another leg lower or a wider recovery.
For traders, the question on whether a rebound is going to form a meaningful bottom or simply provide a short-lived rebound before we head higher again is always going to be hugely important. So, when discussing markets, there is a common perception that if selling is rapid and long-standing enough, then a subsequent rebound is more likely to simply provide a short-term reprieve rather than form a market bottom.
How to trade a dead cat bounce
To a large extent, the view that we could see a dead-cat-bounce is the opposite from a buy-the-dip mentality, where traders are confident that the wider uptrend is going to come back into play despite recent losses. Perhaps bitcoin would be a good example of how a market can go from a buy-the-dip mentality to one of expecting that each rebound is merely going to be a dead cat bounce.
The four-hour bitcoin chart below highlights the run up to $20,000, with each fall being met by buyers, taking advantage of each decline given their perception that history will be repeated to spark further highs.
Fast forward, and markets see each leg lower as being a precursor to further losses. Periods of selling are more protracted, while rebounds are typically fleeting, given the expectation that they may not last. The use of Fibonacci retracement levels can provide us with another tool for spotting the kind of market we are looking at, with shallower retracements indicative of a market which is geared up for another dead cat bounce.
The two sharp declines seen in the chart below, highlight how a market in free fall will typically see shallow retracements where there isn't enough confidence in any rebound.
When seeking to classify a rebound as simply a dead cat bounce, it is important to look for a break through the prior swing low, thus continuing the downtrend. When looking to take advantage of such a market phenomenon, traders can look towards these shallow retracements (<38.2%) as a possible method used to drive strong risk-to-reward trades. Typically, when looking for a location for your stop loss, a smaller sized stop loss will provide a greater possibility for a high risk-to-reward profile. With that in mind, shallow dead cat bounces allow for close stop losses relative to the kind of volatility that has gone before it.
By utilising the prior swing low as the entry point, we are ensuring that the trade is opened upon confirmation that a dead cat bounce has occurred. We then look at the dead cat bounce for a guide on where to place our stop loss, with the shallow nature of that rebound allowing for a relatively small stop loss. It is important to place stop losses above the peak of the dead cat bounce rather than at the peak, given that a higher high would be needed to negate the bearish view.
Taking it back to that previous example, a short trade would be entered at the break back below the $5202 swing low. We can see that the prior retracement was relatively shallow, given that it came in at the 38.2% level. By placing the stop loss above that area, we have a loss of around 500 points to the upside. However, we ultimately saw the price decline rapidly, hitting the 2/1 risk-to-reward target within 30 hours. The 3/1 target is hit five days after entry. Of course, there is a possibility to look for this pattern within shorter or longer timeframe charts which will greatly alter the amount of time you remain within the trade.
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