Trading is bound to have its ups and downs. You might find yourself executing a successful strategy or sometimes getting drawn into the wrong side of the trade. Market commentators have come up with colorful phrases to describe trading conditions, like catching a falling knife or trading in bear or bull traps. A dead cat bounce is another way you could find yourself on the wrong side of a trade. The sudden rise in the price of a security may raise false hopes of a reversal. Here are some ways you could watch out for a dead cat bounce.
What Is a Dead Cat Bounce?
A dead cat bounce refers to a short or temporary rise in the price of a security after a significant decline. The phrase comes from the notion that a dead cat might bounce if dropped from a significant height but wouldn’t be able to recover longer term. Within markets, a dead cat bounce implies a temporary recovery in the value of an asset following a significant and protracted decline.
This short-term market rally could mislead investors into thinking that the asset in a downtrend has bottomed and is reversing upward, which signals a good time to buy. But in many cases, the price will continue to fall after the bounce, resulting in additional losses for those who invested too soon.
What Causes a Cat to Bounce?
Literally speaking, if a dead cat fell from a considerable height, it might bounce. In stock market terms, a cat in the form of a stock could bounce if there is renewed temporary investor interest in the stock. This could be through positive news, a brief change in market sentiment, or traders closing out short positions.
How to Identify a Dead Cat Bounce
A dead cat bounce can be misleading. Sometimes prices are driven higher by speculators hoping to engineer a reversal or short traders covering their positions. In the moment it can be difficult to identify. Nevertheless, there are a few ways to figure out whether you are seeing a dead cat bounce. Take a look at some of them.
1. A Short-Lived Rally
Short-lived rallies are the signature mark of a dead cat bounce. The rally loses momentum just as fast as it started, trapping many bullish traders in the process. Sometimes, there is a gap-up in the stock price followed by a sustained decline. A gap-up is when the price of an asset opens higher than its previous close, creating a gap.
2. A Lack of Volume
Rallies that occur during a dead cat bounce are short-lived because there is not enough buying volume. Buyers who caused the spike in price cannot sustain the trend, leading to a steeper decline. The lack of buying volume may also be attributed to traders using the sudden increase in price as an opportunity to cut their losses and exit positions.
3. A Lower High
What differentiates a dead cat bounce from a market reversal is a lower high. This means that the closing price of a time frame, whether it’s 15 mins or one hour, is lower than the close of the previous one. Again, this is attributed to low buying volume and the inability of buyers to sustain the bullish trend.
Limitations in Identifying
Here are the limitations in identifying a dead cat bounce.
1. Identifiable in Hindsight
A dead cat bounce often can only be confirmed after it has happened, not before. Even the occurrence of chart patterns such as lower highs does not guarantee that the trend reversal is a dead cat bounce.
3. Impossible to Time the Market
It is hard to tell whether the rising trend is a dead cat bounce or a sign that the market is changing. In reality, there is no easy answer to this question. If it were possible to time the market, investors would not get sucked into a dead cat bounce thinking it's a market reversal.
What Does a Dead Cat Bounce Tell Traders?
A dead cat bounce indicates that there is still strong selling pressure on the stock. The bearish sentiment is evidenced by the short-lived rally and lower high. The inability of the buyers to sustain the rally means the stock has not bottomed and would continue to decline further.
Example
There are countless examples of the dead cat bounce pattern in stocks and other securities as well as entire markets. Perhaps the most memorable is the market downfall at the height of the COVID pandemic.
The U.S. indexes lost about 12% during one week in February 2020. This was followed by a 2% gain the following week, only for the market to plummet further until June when the stock market recovery began.
Timing the Market is Tough
It can be too hard for most investors to distinguish between a dead cat bounce and a bona fide rally. Still, knowing what to look for may help investors make better trading decisions — especially when it comes to making a choice between keeping or closing out a short position based on a stock's price action.
Bear in mind that it is generally not possible to know about a dead cat bounce until after it has occurred. Trying to time a market bottom might only lead to more losses. As such, when choosing a stock to invest in, hinge your decisions on a combination of fundamentals and technical analysis. Certain technical signs may point to short-term trends that are transient. Invest with caution and know your limits.
Frequently Asked Questions
How long does a dead cat bounce last?
Dead cat bounces last from the first reversal in price action until prices drop again. They are generally short-lived and may not last long.
What is the opposite of a dead cat bounce?
The opposite of a dead cat bounce is a reversal or market rally.
Can you predict a dead cat bounce?
It is usually not possible to predict a dead cat bounce. They are often identified after the fact, not before.
About Anna Yen
Anna Yen, CFA is an investment writer with over two decades of professional finance and writing experience in roles within JPMorgan and UBS derivatives, asset management, crypto, and Family Money Map. She specializes in writing about investment topics ranging from traditional asset classes and derivatives to alternatives like cryptocurrency and real estate. Her work has been published on sites like Quicken and the crypto exchange Bybit.