Trading a Dead Cat Bounce

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Extremely volatile markets create an environment for the formation of a very specific type of technical price pattern. The “Dead Cat Bounce” pattern (DCB) may have a macabre name but it comes with very nice profit potential and is relatively easy to identify.

At its heart the DCB is a great study in investor psychology. It occurs when investors have panicked or have been caught by surprise which is why the pattern occurs most frequently in bearish and volatile markets.

[VIDEO] Dead Cat Bounce, Part 1

Investor psychology comes into play because traders are likely to become fearful at the same price levels that they have been fearful before. We use the DCB to identify those price levels for potential breakouts.

The pattern consists of a gap during a downtrend when prices have moved between the close of one day and the open of the next trading day. The larger the gap is the more significance technicians will assign to the pattern. The gap is typically created by unexpected news appearing after or before normal market hours.

The gaps indicates that traders have “overreacted” to the data, the stock is likely to become oversold at some point and will begin to retrace back towards the gap. The top and bottom of the gap will act as resistance barriers and if the market or stock peels off of these resistance levels, the subsequent decline can be quite significant.

The rally back towards the gap is a good example of a bull trap and the final decline that completes the pattern can be larges and fast as a feedback loop of stop losses push more sellers into the market.

Example of a dead-cat-bounce

Dead Cat Bounce

In the chart above you can see a DCB that formed on Goldman Sachs (GS.) Once a breakout to the downside occurs, shorts enter the market. Buying puts at this point is a great way to limit your risk while still taking advantage of the downside potential.

In the video, I will cover the pattern in more detail with a few additional examples. In the next article in this series I will show you how you can project price targets once the pattern has completed itself.

Forecasting a Dead Cat Bounce

Identifying a dead cat bounce is just part of the challenge. Estimating or forecasting the likely distance the stock will move following the pattern’s confirmation is also important. This is a challenge for technical analysts as much as it is for fundamental analysts. Creating an estimated profit target will help you make better decisions about the trading strategy you will use to take advantage of the price move.

[VIDEO] Dead Cat Bounce, Part 2

There is a reasonably easy way to start making these estimates following the bounce back down from resistance. To do this we will be using fibonacci retracements, which are one of the primary tools used by technicians to identify support and resistance levels and to make price projections. The same technique you see in this article can be applied on many other technical patterns as well.

The image below illustrates how this analysis is conducted. A fibonacci retracement is drawn from the first bottom following the gap (point A) to the break down from resistance at the gap (point B). The retracement lines themselves can be ignored because what you are interested is past the first low at the 161.8% projection level (point C).

Dead Cat Bounce 2

As you can see in the case study above this price was easily reached. Of course, ongoing trade management continues to be important but this analysis provides a solid starting point for evaluating the opportunity.

Based on the estimate you can decide how to best take advantage of the opportunity. A very tight profit target may be difficult to trade with a long option and a short call sold above resistance may be more attractive. Conversely a very long profit target could be ideal for a long option that retains unlimited profit potential.

Trading a technical price pattern is a three step process. First we identify the pattern and wait for confirmation. Second, the an initial price target estimate is produced. Third, using the information gathered in the first two steps you can select the right trade strategy and actively manage the position. Approaching an opportunity this way helps traders maximize a profit opportunity.