How to Spot and Trade a ‘Dead Cat Bounce’

In recent weeks, we have seen a lot of volatility in the financial market. The amount of volatility, as measured by the CBOE volatility index, has increased by more than 100% as market participants fear about a recession.

As a result, global stocks have fallen by more than 20% while the dollar index has strengthened. Gold and Bitcoin, often viewed as safe-haven assets have wobbled too.

In this report, we will look at the concept of dead cat bounce, which will help you navigate the financial markets in time of volatility.

How to stay safe from recessions

What is a Dead Cat Bounce?

A dead cat bounce is an important concept (and a price pattern) that will help you avoid making mistakes at a time when markets are volatile.

The idea behind it is simple: when you toss a dead cat, it will bounce and then go back to the ground because it is still dead. It will do this because it does not have life in it.

A dead cat bounce happens when a financial asset like stock, commodity, currency pair, or an index is declining. As it declines, the asset could rise for a day or two and then continues to decline again.

As it does this, traders who bought the bounce see significant losses.

The alternative too is true. A financial asset can jump or rise because of a certain reason. In such a case, a dead cat bounce can happen if the price declines for a day or two and then resumes moving upwards again.

Why Does a Dead Cat Bounce Happen?

A dead cat bounce happens mostly because of the herd mentality in the market. This is a mentality where traders tend to follow the crowd. Therefore, as the price recovers, they hope that a new long-term trend is just getting started.

However, as they do this, the market is still worried about the main reasons for the decline of the price. In most cases, the people who suffer during a dead cat bounce are usually retail traders.

Useful Examples of DCB

In this report, we will look at two recent examples of a dead cat bounce. The first example is on the S&P 500.

dead-cat-bounce-s&p500

Dead Cat Bounce in S&P 500

The chart above shows that the S&P 500 was declining between February and March 2020 as the reports of coronavirus dominated headlines.

The price declined because market participants and economists started to warn of a recession or depression as businesses and shut. As the price was declining, we saw a few days when it rose.

As it rose, we heard several market commentators try to call a bottom but the price declined the following day.

In the chart below, we see that the price of crude oil was in a downward trend. The price had just moved from above $50 per barrel to less than $30 in just a few days. As the price declined, it also made a few dead cat bounces as traders started to price-in a recovery.

dead-cat-bounce-in-crude-oil

Another example of DCB in the Price of Crude Oil

When it Happen

In most cases, dead cat bounces happen after a significant news about a stock, currency pair, or commodity. For example, a company’s stock will move sharply after it makes a significant announcement. This can be a negative earnings report or forecast.

It can also be a major news like the resignation of a CEO or a flop of a major product.

In currencies, such a price action can happen after the central bank rises or slashes interest rates or when a country releases negative economic data like employment and manufacturing PMIs.

How to Trade Dead Cat Bounces

There are two main things you need to know about dead cat bounces. First, you should always avoid timing the market. By this, we mean that you should avoid going against the overall trend especially when more news is coming in.

For example, on coronavirus, you should avoid going long when the market and news media are continuing to focus on the news.

Second, you should always wait before you go against a trend. In other words, you should follow the trend. This means that you should wait for a new trend to form and then you follow it.

Finally, you should always have a stop loss on all of your trades.

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