They say that what happens must go down, but an equally true and less discussed phenomenon is that what goes down must go up. At least sometimes.
The idea of ”bouncing a dead cat” may sound a bit unsettling, but if you hear it mentioned in a trading context, it refers to a specific phenomenon in the stock market.
This phrase comes from the idea that even dead cats jump if they fall from a high enough point. When asset prices hit high levels and then fall, they can temporarily rebound – even if the asset is ultimately dead and immediately plummets again.
Why should you care? Because by following proven trading strategies, you can use them to make a profit. In this article I will tell you:
- What is it and how does it work
- Why do they happen
- The economic forces behind them
- How to monitor your trading psychology when trading them
- Real life examples
- How to trade bounces
What is Dead Cat Bouncing?
In the media, asset prices are often discussed as if they are either in a sustained uptrend or in a sustained downtrend. As an investor or trader, you know this is far from the complete picture.
When the price of a stock is down, it rarely just falls straight down without experiencing a few peaks. One extreme example of this is the bouncing of a dead cat: when the price of a stock declines, it may seem like it is retracing a bit before returning to its previous low.
In early 2020, the stock market experienced a rapid and sharp decline, it was the rebound that prevented an almost vertical downward line.
To understand exactly how this works, let’s look at what happens to a stock when its value starts to fall.
Most investors will panic – they will try to get their money out, some traders will take the opportunity to short, and very few buyers will want to invest. Even if we don’t act accordingly, we are likely to panic as the human brain is programmed to respond emotionally.
In fact, if we look at things rationally, we can see that the price is unlikely to continue to decline indefinitely. At some point, the panic will subside and the price will rise slightly again. That’s when traders and investors can take action – if they’re smart.
Unfortunately, many traders mistake this small mark for a genuine recovery. At this point, you are probably wondering why is this happening at all?
What are the reasons?
A rebound occurs when pessimism begins to shift into a bear market. If the market has been in a downtrend continuously for several weeks, the conditions for a rebound begin to intensify – and this is made possible by the way different types of traders operate.
Bears will short sell, hoping they can profit as the price continues to fall.
However, value investors (who are looking for undervalued stocks) can buy them because they believe the stock will rise in value.
At some point, traders who are short will want to make money and close their short positions. Thus, they transform from sellers to buyers, which increases the value of purchases for investors.
Even though stocks are “dead,” this activity leads to a temporary increase in demand.
The market environment is dominated by tensions between bullish and bearish sentiments, as well as the question of whether the market fell too early or has a long fall ahead.
Economy in the game
As you probably well know, there are two main forces at work in the economy: supply and demand.
In the event of a rebound, the power of supply consists of investors who go short, while investors stimulate demand because they believe the stock price is about to rise.
To begin with, the supply of traders willing to sell outstrips demand, so the price continues to fall and fall (as the supply curve shifts outward and the demand curve shifts inward).
But when some people think that the price has become too low and want to buy, the demand curve temporarily shifts outward again, increasing the price, but soon it will return to normal again.
Obviously, this is an extremely simplistic way of looking at a complex scenario.
Market psychology
In retrospect, the path to profit from bounce seems as clear as day. So why are so many traders burned by them instead of making a profit?
Partly because they are blinded by short-term moves (bounces) to notice broader trends, and partly because they have failed to cope with their emotions associated with their investment decisions.
Greedy traders don’t want to pat themselves on the back and take their leave when the stocks they were trading at the bottom increase in value by 10% – or even 20%. So they hold on for too long and end up causing losses.
Likewise, frightened traders can panic as soon as they see the price of one of their investments go down, even if there is a bounce at some point.
The lack of impulsive control over greed and fear sets traders to fail. Accept that you will never be perfectly timed in the market (develop a strategy that reflects this) – and that this is not necessary to be successful.
This is why I have invested a lot of time and money in working on my trading psychology, which in these crucial moments has improved my decision-making ad infinitum.
Real world examples
Theoretically speaking is good, but to understand how to trade these things, you must be able to recognize patterns.
They say that you cannot understand the future if you do not understand the past, so here are three real-life examples.
All of these case studies focus on larger trends that have taken place over weeks or even months, but a dead cat’s bouncing can also stop within days – as in the 2020 crash example I mentioned earlier. There is no set time frame for when the rebound will start or end.
The Great Depression
Few periods in financial history are mentioned more often than the Great Depression.
We tend to look at this as a period of sharp and prolonged falls. History gives us the opportunity to forget, because at that time it was not so easy.
After the initial crash in 1929, from late 1929 to the spring of 1930, stock prices rose 47% – a near full recovery.
As you no doubt guessed, prices soon plummeted and soon dropped 80%.
The depression also included many other mini-rallies and rebounds.
S&P 500 in 1974
Unsurprisingly, you don’t have to go back to 1929 to find examples of rebounds – although nothing else is that dramatic.
In November 1974, the S&P 500 plummeted, rallied about 17%, and then fell back to its previous low.
NASDAQ in 2000
A similar case happened in 2000 with the NASDAQ. The index fell 27% between September 1 and October 17, after which it unexpectedly recovered 9% (and then fell again).
Other indices at the time showed similar patterns, albeit less pronounced.
These are three examples out of many. Price never goes straight down (or up), so if you can recall any past examples of a stock bottoming out, chances are high it may have experienced a short bounce at first.
Reversal or Rebound?
It’s easy to assume that a long period of decline will automatically lead to a rebound, especially after the three historical examples we just saw. But don’t be so confident. Sometimes there is a complete recovery and an upward trend.
Figuring out the difference between a reversal and a bounce is one of the most difficult elements of this type of trading, and I would like to give you a surefire trick on how to do it. Unfortunately, I cannot but recommend that you use your knowledge of market fundamentals and your knowledge of your trading style and psychology.
However, here are some rules of thumb.
Wait for the value to increase first, then look for some more bounce signals.
One of the telltale signs is a reversal or bearish pattern at the top of a dead cat bounce, like a double top that fails. At this point, you can go short with less risk.
Alternatively, you can wait until the price drops below support levels (previous declines and rallies before significant gains).
Ultimately, you are looking for a sign that the forces of supply and demand are changing.
How to insure
Once stock prices plummet and then begin to rise again, going short may seem like an attractive prospect.
At this point, it is important to ensure that you do not misinterpret a rebound as a reversal, exposing more capital than planned.
The “test” you can try is to wait to see if the price returns to its previous low. If a few days have passed and the price has remained comfortably above the previous low, this is a sign that you may be facing a real recovery.
You can expect to see a kind of imperfect “W” retracement as the price consistently falls and then rises again.
When this happens, I recommend setting your stop loss just below the first V so that you can exit if the price does crash (more on risk and stop loss later).
This leads to something you will no doubt want to read about: refining your strategy.
Dead cat bounce strategy
Now that you have a good understanding of how dead cat bouncing works, we can move on to the important question: how can you successfully trade dead cat bouncing?
The first thing to know is that every jump of a dead cat is slightly different, so don’t wait for a tutorial example every time. You cannot assume that the market is bouncing just because the recession was followed by a rally – that could mean anything (as we have already seen).
Now that we have it sorted out, let’s move on to strategy. You could probably talk to hundreds of different traders on how best to do this and get hundreds of different answers, but I recommend using a bounce to open a short position.
It is generally better to trade when you suspect that prices are about to fall than when you suspect that prices will rise – there is less risk.
To do this, it is important to make sure that you can distinguish a rebound from a retracement (which is bad news for anyone short) – use the methods outlined above to do this.
In the case of the W-shape, after you notice signs of a slight bounce, wait for the price to exhaust itself.
One of the signs of this is the price increase during the close or approaching the opening price, and the other is panic buying (the open price is higher than the previous close, but then falls below the lowest point of the previous day).
Resist the temptation to cut the bounce by joining the trend as prices go down. You can expect them to drop more often, but this is rarely a good idea – they are so easy to catch. Instead, wait until the minimum is found.
Stop placements and targets
To deal effectively with bounces, you need stop losses and price targets.
Place price targets for the short position above the previously reached low. Then when the price rises again, exit. In the event of a short circuit, do the opposite. Place your stop loss just above the recent high.
As a rule of thumb, try to keep stops and price targets from being placed outside of the normal swing range lest you be caught off guard.
Bottom line
Successfully trading a dead cat bounce is no easy feat. This is a somewhat risky tactic that usually requires a fair amount of practice to get it right, plus a solid understanding of how to analyze asset prices and asset patterns.
But with the right approach, it can certainly be very profitable and an important strategy for every trader or investor; add to their bow.
This article originally appeared on Your Money Geek and has been republished with permission.