As crude as it may sound, the dead can bounce can be a rewarding trade if timed correctly. As the name suggests, it refers to a bounce (or minor rally) which then turns swiftly lower. One of the first known references in mainstream media to the term was in Financial Times article in 1985, although its actual origin is unknown.
As a rule of thumb, the more reliable dead cat bounces appear after a large, bearish breakaway gap or price spike. This makes sense, as breakaway gaps appear at the beginning of a downtrend, and the dead cat bounce itself is simply a minor pause in a downwards move.
In some ways it could be compared to a flag or a pennant, although there are some characteristics which are specific to this type of pattern.
Characteristics of a Dead Cat Bounce
- It is a retracement agains a bearish move.
- The market has just fallen sharply.
- The 'bounce' is relatively minor compared with the initial leg lower.
- There is usually an event stock / fundamental story behind the decline.
- It can be reminiscent of other patterns such as flags or pennants, although there's no definitain of its actual shape. This can make it tricky to trade.
Dead Cat Bounce on DJIA (US30) in 2020
US indices produced classic examples of a Dead Cat Bounce in February 2020, although we chose the DJIA as it produced the smallest bounce compared to the S&P 500 (US500) and Nasdaq 100 (USTEC) to suggest it was the weakest of the three markets.
It is a great example as it includes the following characteristics
- Event shock: Global risk-off event triggered by Covid-19 lockdowns
- Breakaway gap lower: Prices were falling out of market hours
- Strong initial move lower: At this point, some bears would be side-lined waiting for an opportunity (retracement) to sell.
- Retracement last a few days: Whilst price action was choppy, DJIA produced the weakest counter-trend move
- Bearish follow-through: Note how a dark cloud cover formed two days before gapping lower and the bearish trend accelerated
As price action on the daily chart was quite choppy during the retracement, a trader could have switched to a lower timeframe for further analysis. So we’ll take a look at H4 (four-hour chart) to see how price action unfolded.
On the 3rd of March a key reversal / bearish outside bar suggested resistance and a potential swing high was in place at 27,060. Whilst prices went on to confirm a retracement line the next day, the high of the session failed to close above the key reversal candle to reaffirm resistance at 27,060.
- At this point, the trader could have considered entering a break of the retracement line, with a view to exit a trade if prices broke back above 27,060 resistance.
- A more conservative approach would have been to wait for a break of the cycle low (24,670) to confirm a resumption of the downtrend.
- If that was missed, another possible short entry to consider could have been a break of the next cycle low (23,426).
How to Approach a Dead Cat Bounce (DCB)
Obviously we had the benefit of hindsight in the above example, but hopefully it demonstrates that a trader can refer to other traditional forms of technical analysis to trade around, or after, a dead cat bounce has appeared.
Not all examples will be this perfect but here are some basic guidelines to consider in future.
- If bullish momentum swiftly returns, it’s less likely to be a DCB and improves the potential for a V-shaped bottom.
- If the trader suspects a DCB is forming, seek bearish reversal patterns on current timeframe.
- If price action is messy on the current timeframe, refer to lower timeframe analysis.
- If they are an EOD trader they could consider using a limit order with a relatively wide stop, to try and ride out any noise on the charts and catch a retracement top. Of course, the risk here is being triggered into a strong rally and being stopped out, in which case they could use smaller positions than usual. Another approach is to wait for a break of cycle lows.
- If a DCB is identified after the fact, refer to traditional trend analysis.