The stock market is full of ups and downs, and sometimes the movements can be deceiving. One of the terms that investors use to describe a misleading price movement is a dead cat bounce. But what does it mean, and how can you identify it?
Definition of a Dead Cat Bounce
A dead cat bounce is a temporary and deceptive recovery in the price of a stock or an index after a significant decline. It is a phenomenon where the price experiences a short-lived upward movement, giving the impression of a potential market reversal and enticing some traders to believe that the worst is over.
The term “dead cat bounce” may seem peculiar, but it is derived from the idea that even a dead cat will bounce if it falls from a great height, but it doesn’t mean that the cat is suddenly alive again. Similarly, in the stock market, the dead cat bounce suggests that the temporary rise in price is merely a reflexive rebound and does not indicate a long-term bullish reversal.
Causes of a Dead Cat Bounce
A dead cat bounce typically occurs after a significant and rapid decline in the price of a stock or an index. It is often associated with market panic, investor sentiment, or negative news that triggers a significant sell-off. The sudden drop in price creates an oversold condition, meaning that the price has fallen below its intrinsic value.
Some of the factors that can cause a dead cat bounce are:
- Short covering: Short sellers are traders who bet on the price of a stock to go down by borrowing and selling it, hoping to buy it back later at a lower price and pocket the difference. When the price of a stock drops sharply, short sellers may decide to close their positions and lock in their profits by buying back the stock. This creates a sudden increase in demand and pushes the price up temporarily.
- Bargain hunting: Some traders or investors may see the steep decline in price as an opportunity to buy the stock at a discounted price, expecting that the price will eventually recover. This also creates a temporary increase in demand and pushes the price up.
- Technical analysis: Some traders or investors may use technical analysis tools, such as moving averages, trend lines, or support and resistance levels, to identify potential entry or exit points for their trades. When the price of a stock reaches a certain level that is considered to be a support or a bounce zone, some traders may buy the stock, expecting that the price will bounce back from that level. This also creates a temporary increase in demand and pushes the price up.
Examples of a Dead Cat Bounce
To illustrate the concept of a dead cat bounce, let us look at some examples from the past:
- The 2008 financial crisis: One of the most notorious examples of a dead cat bounce occurred during the 2008 financial crisis, which was triggered by the collapse of the US housing market and the subprime mortgage crisis. The S&P 500 index, which tracks the performance of 500 large US companies, plunged by more than 50% from its peak in October 2007 to its trough in March 2009. However, along the way, there were several instances of dead cat bounces, where the index rallied by more than 10% before resuming its downtrend. For example, in November 2008, the index rose by 18% in a span of five days, only to fall by 25% in the next month. Similarly, in January 2009, the index rose by 14% in a span of 10 days, only to fall by 18% in the next month.
- The dot-com bubble: Another famous example of a dead cat bounce occurred during the dot-com bubble, which was a period of excessive speculation and valuation of internet-related companies in the late 1990s and early 2000s. The Nasdaq Composite index, which tracks the performance of more than 3,000 US technology companies, soared by more than 500% from 1995 to 2000, reaching a peak of 5,048 points in March 2000. However, the bubble soon burst, and the index plummeted by more than 75% by October 2002. Along the way, there were several instances of dead cat bounces, where the index rallied by more than 20% before resuming its downtrend. For example, in April 2000, the index rose by 34% in a span of 10 days, only to fall by 37% in the next month. Similarly, in July 2000, the index rose by 22% in a span of 10 days, only to fall by 27% in the next month.
How to Trade a Dead Cat Bounce
Identifying a dead cat bounce is crucial for traders and investors to avoid falling into the trap of false market reversals. In this section, we will explore some of the strategies and tips that can help in trading a dead cat bounce.
- Use multiple indicators: One of the challenges of identifying a dead cat bounce is that it can be difficult to distinguish it from a genuine market reversal. Therefore, it is advisable to use multiple indicators, such as price, volume, fundamentals, and sentiment, to confirm the nature of the price movement. For example, a dead cat bounce is often characterized by lower trading volume compared to the volume during the initial decline, indicating a lack of strong buying interest and suggesting that the bounce is not sustainable. Similarly, a dead cat bounce is often accompanied by a lack of fundamental support, meaning that there are no positive changes in the underlying factors driving the initial decline, such as earnings, revenues, growth, or outlook. Moreover, a dead cat bounce is often influenced by negative market sentiment, meaning that there is widespread fear, uncertainty, or negative news impacting the market, which can contribute to the occurrence of a fake reversal.
- Use stop-loss orders: A stop-loss order is an order that automatically closes a trade when the price reaches a predetermined level, either above or below the current price. It is a useful tool to limit the risk and protect the profits of a trade. When trading a dead cat bounce, it is important to use stop-loss orders to avoid losing money if the price moves against the expected direction. For example, if a trader is shorting a stock that is experiencing a dead cat bounce, they can place a stop-loss order above the resistance level or the previous high of the bounce, to exit the trade if the price breaks above that level, indicating a possible reversal. Similarly, if a trader is buying a stock that is experiencing a dead cat bounce, they can place a stop-loss order below the support level or the previous low of the bounce, to exit the trade if the price breaks below that level, indicating a possible continuation of the downtrend.
- Use time frames: A time frame is the period of time that is displayed on a chart, such as minutes, hours, days, weeks, or months. Different time frames can show different patterns and trends of the price movement. When trading a dead cat bounce, it is important to use multiple time frames to get a better perspective of the overall market direction and the strength of the bounce. For example, a trader can use a longer time frame, such as a daily or a weekly chart, to identify the main trend and the key support and resistance levels of the market. Then, they can use a shorter time frame, such as an hourly or a 15-minute chart, to identify the entry and exit points of the trade, based on the price action and the indicators of the bounce.