Why yes, Dead Cat Bounce is the name of a rock band … but that’s not the topic of conversation today.
In the context of the stock market, a dead cat bounce is a specific type of stock chart pattern phenomenon occurring in downward trending stocks. That’s what we’re talking about today.
While a down-trending market can be a real bummer, there are certain opportunities that this pattern can offer, particularly for short sellers.
Here, you’ll get schooled on the dead cat bounce pattern, including what it is, how to spot it, and tips for how you can use it when seeking out potential trades.
Table of Contents
- 1 What Is The Dead Cat Bounce Pattern?
- 1.1 Benefits of Trading The Dead Cat Bounce Pattern
- 1.2 How The Dead Cat Bounce Pattern Occurs
- 1.3 Examples of How to Spot a Dead Cat Bounce Pattern
- 1.4 #1: India Globalization Capital, Inc. (IGCC)
- 1.5 #2 Achieve Life Sciences Inc (ACHV)
- 1.6 #3 Zosano Pharma Corporation (ZSAN)
- 2 Key Trading Tips for Using the Dead Cat Bounce Pattern
- 3 The Bottom Line
What Is The Dead Cat Bounce Pattern?
Perhaps one of the most memorably-named stock chart patterns, a dead cat bounce refers to a specific chart pattern where the stock’s price has a big drop, followed by a brief recovery (or “bounce”) before the descent continues.
The funny name has been actively used since the 1980s, when Asian markets were falling hard, then had a brief recovery before continuing an ailing trajectory.
This phenomenon was called a dead cat bounce, going from the adage that “even a dead cat will bounce.”
It was an undoubtedly catchy phrase, so it didn’t take long for the concept to catch on. Now, the dead cat bounce can refer to this sort of action in stocks, forex, commodities, and even beyond the financial sphere.
Benefits of Trading The Dead Cat Bounce Pattern
The dead cat bounce might sound like a real downer, but there are plenty of benefits it can offer, including:
- A helpful indicator. A dead cat bounce can be an indicator of market weakness, either in the market at large, or within a certain sector. While nobody likes to see things go downhill in the economy, it’s good to know what you’re up against in the market, because this allows you to create the most effective trading strategies.
- High volatility. Day traders love volatility. Well, maybe not love it, but they recognize that volatility can cause the spikes that they’re hoping can help them generate profits. A dead cat bounce can be a big short term spike, so as a day trader, you could benefit from this phenomenon.
- Opportunities to buy low. It’s possible to benefit from a dead cat bounce by buying shares when the stock hits a low point and then unloading them during the bounce. However, it’s important to keep in mind that it can be very hard to determine if it’s a dead cat bounce or if it’s a trend reversal.
- Opportunities for short sellers. If you’ve done good technical analysis and determined that a stock is experiencing the dead cat bounce pattern and not a trend reversal, it could be a good time to get into a short-selling position. If the price continues to go down, there could be a potential to profit.
- It can repeat. Sometimes, a dead cat can bounce more than once. If you look at a stock’s chart, you may notice that there are bounces at regular intervals. If so, it could be a pattern worth looking at, because it could repeat again.
How The Dead Cat Bounce Pattern Occurs
So you know that the dead cat bounce is characterized by a stock taking a dive, bouncing back, and then continuing to lose momentum. But what causes it, and how does it play out?
Consider a stock that has been slowly but steadily declining for a few weeks in a row.
Short traders are seeing the decline and beginning to think, “maybe I should exit here and take my profits”.
At the same time, the trade can become enticing for people looking for a good value. This could cause a flurry of buying activity.
You could think of it like a pressure system that you’d see on the Weather Channel. When these two things happen at the same time, they create a pressure that causes the perfect storm, briefly making the stock spike.
However, the pressure is unsustainable, and after the flurry of activity, the downward crash continues.
This is a pattern that we’ve seen play out over and over throughout the years. For instance, during the dot-com crash in the early 2000s, there was a brief rally in stock prices before the downward spiral continued.
Ultimately, uncertainty is what causes a dead cat bounce. When the long downward direction goes on, some traders will think the market has reached the bottom, which spurs activity for both long and short buyers.
Examples of How to Spot a Dead Cat Bounce Pattern
#1: India Globalization Capital, Inc. (IGCC)
India Globalization Capital, Inc., is a company involved in creating and commercializing cannabis products to help treat medical conditions. In recent months, while shares have largely been trending down, they have experienced a few bounces that could be classified as dead cat bounces.
What Can You Learn From This Stock Chart
In looking at this chart, a key lesson is that “what goes up must come down.” Quick, violent spikes in price are rarely sustainable, and this chart is a good example of what can happen in the aftermath.
#2 Achieve Life Sciences Inc (ACHV)
This specialty pharmaceutical operation works with medications meant to help people quit smoking. Last year, following positive results of a clinical study, the share price skyrocketed, but quickly declined, with several bounces along the way.
What Can You Learn From This Stock Chart
With biotech companies, news catalysts can be extremely fickle and short-lived. It’s very important to stay on top of clinical trials, the results, and to keep an eye on the company’s balance sheet.
#3 Zosano Pharma Corporation (ZSAN)
Zosano Pharma Corporation is a pharma company involved in the development of a proprietary dermally applied microneedle drug delivery system to treat migraines. Last year, they had a reverse split, which caused a decline in price. However, there was one big bounce last year, and another just recently.
What Can You Learn From This Stock Chart
Reverse splits can often cause a decline in stock price.
In case you’re not familiar, a reverse split is the opposite of a traditional stock split. It’s usually performed by companies with low share prices. The reverse split will actually increase the share price, but reduce the overall amount of shares available.
So, for if a company does a 4-for-1 reverse split, if they have 4 million shares outstanding with a price of $1 per share, they would now only have 1 million shares outstanding with a price of $4 per share.
The split itself doesn’t change the value of the company, and the dollar amount of the total shares remains the same.
Often, companies perform a reverse split because they are trying to avoid being delisted from an exchange because of the low share price. This isn’t always the case, though; sometimes they want to increase the share price to make the jump to a larger exchange.
Why would a reverse split affect a company negatively? Because it can look like a big red flag to traders, particularly if the shares have been waning recently.
However, the descent isn’t always without a few bounces, as you can see by this chart. Sometimes a spike can occur that can create opportunities for traders.
Key Trading Tips for Using the Dead Cat Bounce Pattern
Interested in trying your hand at stock plays using the dead cat bounce pattern? Here are some tips to help you approach trades responsibly.
Always Use a Stop Loss
Things can happen fast with a dead cat bounce.
Once you’ve found a dead cat bounce and decide to sell short, it’s important to short when the price action is breaking and goes below the last bottom.
By timing it outright, you can maximize the potential for taking advantage of the continuing price decrease.
The thing is, this can happen very, very quickly. And adding to the stress of the situation, you can’t always be sure that it’s just a bounce. Sometimes, what you think is a dead cat bounce could be a longer-term trend reversal. If you’re a short seller, that is not desirable!
To stay as safe as possible, it’s a good idea to place a stop loss order.
A stop loss order is a way to help limit your losses, and as you know, I consider minimizing losses to be one of the most important things you can do as a trader.
With a stop loss, you determine the maximum losses you’re willing to sustain and set an order. If the price goes below the stop level you establish, your position will be closed, meaning that you can avoid further losses.
Because things can change and quickly, a stop loss order can help you mitigate risk and help you cut losses quickly if needed.
How to set the stop loss? Well, that will ultimately depend on the volatility and the price of the stock in question. For example, a low priced stock might require a fairly small stop loss, but if the stock price is $100 per share, things are a bit different.
For a reference point, many traders will choose to set the stop loss just a little higher than the top of the pullback (the short term price drop) to help reduce risk. Why? Because if the trend does continue to move upward, as a short seller you could really lose big.
Never Trade Too Big
In case I haven’t stressed it enough, dead cat bounces can be risky. Any type of trading can be risky, of course, but because of the fast pace and uncertainty involved in dead cat bounces, they present a particularly high level of risk.
Yes, it’s a pattern, but that doesn’t mean it’s going to play out exactly as you’d expect every single time. There can always be deviations.
As such, you should never trade too big.
With dead cat bounces, it’s important to create a strong trading plan detailing your entry and exit points. A trading plan is super important for every trade, but it’s especially important when trying to take advantage of the dead cat bounce because of the high level of risk and the many unknowns.
When you make a trading plan, you’re forced to do research to make a case for your trade. Not only does this assist you with plotting out how reliable the pattern in question is, but it can help you stay accountable and responsible in the trade.
By looking at the past performance of the stock and considering technical indicators, you can better determine how it might react in the future for the next bounce.
However, even the best-laid plans won’t always work out as you’d like. The market is subject to a myriad of factors like shifts in the economy, catalysts within the sector, et cetera. You can’t count on anything as a sure thing in trading.
That is to say: anything that you put into a trade could potentially be lost. So you don’t want to put more on the line than you’d be able to lose.
So what does trading “too big” mean? This will differ for every trader based on their account size. But ultimately, don’t bet more than you can’t comfortably lose.
There’s a big temptation for traders, especially those with small accounts, to go “all in” with trades. After all, if you want to grow your account fast, you’ve got to go big or go home, right?
Wrong, wrong, wrong. This type of thinking is really more for movie montages than actual life, and in real life you could drain your account in practically the blink of an eye.
Instead of going for an ace in the hole, focus on slow but steady growth. Taking smaller positions is fine, and if your profits are relatively small, that’s ok. Even if your profits after fees are $10 or $15, it’s still $10 or $15 more than you started with.
They will build over time, and so will your experience, so as your account grows so will your knowledge level, and you can begin taking bigger positions.
Improve Your Stock Market Knowledge
Work hard, every single day, to improve your stock market knowledge.
This might seem like an indirect way to improve your dead cat bounce prowess, but trust me, it has everything to do with increasing your odds of finding success with this pattern.
For instance, right now, you’ve taken the time to read this post about dead cat bounces. Just by doing that, you have probably already begun to understand what a dead cat bounce is and how to approach it.
From this point, you have a better sense of direction for how to located dead cat bounces, and what types of strategies you might pursue.
On the flip side, maybe you’ve been reading about dead cat bounces and you think “Nope, that’s not for me.” Believe it or not, even if you have no interest in dead cat bounces, it wasn’t a waste of time to learn about them.
Learning about trading techniques you don’t want to pursue can be helpful too. Why? In choosing not to pursue certain styles of trading, you learn a lot about your personal style as a trader, and you give yourself more space and time to continue working on and refining the techniques you do prefer.
So even if you never intend on trading a dead cat bounce, learning about the pattern can help your trading career.
Overall, the more you learn about the stock market, including common patterns, market mechanics, and how to look at stock charts, the more nimble and knowledgeable you will be.
This means that when it comes time to craft a trading plan, plot entry and exit points or identify trends, you’ll have a bigger wealth of knowledge to draw from.
You’ll literally never know everything there is to know about trading, but that shouldn’t stop you from learning all that you can. More than anything else, this will help you stay adaptable and allow you to evolve along with the market.
I’ve been trading for decades, and I’ve seen cycles come and go. Continuing to learn is one of the biggest ways I’ve been able to stay relevant.
Plenty of market newcomers think that they can learn how to trade by themselves. Plenty of new traders also fail miserably. I can’t help but believe there’s a connection.
Why would you want to go through things the hard way in the market when you could take advantage of someone else’s experience to fast forward through a ton of the difficult stuff?
If you find yourself wanting some market guidance, consider applying for my Trading Challenge.
My Trading Challenge isn’t for just anyone. You need to apply, because I only want to spend my time on motivated students who want to become self-sufficient traders. Get-rich-quick hopefuls and lazy people need not apply.
My Trading Challenge is designed to help traders become self-sufficient. Sure, we’ll cover the basics, but my emphasis is helping you put your trading knowledge to active use.
I don’t want to just give you vocabulary and charts to memorize. I want you to figure out how to form a strong watchlist, calculate and use stock charts to your advantage, and ultimately, find your own success as a trader.
There are plenty of resources in the Challenge, including a huge library of video lessons, tons of webinars and live trading sessions, and of course, I share my regular watchlist every Sunday night.
When you join the Challenge, you get not only a mentor in me but a community in your fellow students. Immersing yourself in trading in this way is one of the best ways to get into the swing of things fast.
The Bottom Line
Downward trending markets and stocks usually aren’t something that gets traders excited. However, when you understand and have the ability to anticipate patterns like the dead cat bounce pattern, you can potentially take advantage of downward trends in the market. Talk about a silver lining!
Of course, it’s important to remember that dead count bounces aren’t infallible. It can be hard to know whether it’s a dead cat bounce or a trend reversal. Understanding all that you can about the market and learning how to evaluate this pattern will help you better determine if this is a style of trading you want to pursue.
Have you tried trading the dead cat bounce pattern? Leave a comment and let me know your experience!