A dead cat bounce is a market trend that indicates a stock is recovering when it really isn’t. Unfortunately, it can result in short-term traders losing money when they bought the stock when it was trending upward.
You may have heard the phrase, “even a dead cat will bounce if it falls from a great height.” It can be applied to many different scenarios, including the stock market. In the case of investing, a dead cat bounce refers to a trend where a stock drastically changes direction twice in a row, going from down to up and, ultimately, back down again.
As a day trader, a dead cat bounce can cause you to lose money if you don’t time your trades correctly. Keep reading to learn how a dead cat bounce works, an example of a dead cat bounce, and how you can successfully trade this market phenomenon.
What is a dead cat bounce?
A dead cat bounce is a sharp decline in a stock’s price followed by a temporary rebound, only to be followed again by another decline that wipes out the previous gains. A dead cat bounce is considered to be a continuation pattern.
While the price increase may at first appear to be a reversal of the stock’s current trend, it ultimately turns out to be short-lived. This is because the stock eventually drops in price once again and continues its previous pattern, possibly falling below its prior low.
A dead cat bounce can cause significant stock market losses for investors who misunderstand the bounce for a long-term rebound and buy the stock just before the price plummets again. However, it can be quite profitable for someone who can properly time the sale of a stock or a short position.
What causes a dead cat bounce?
There’s no one root cause of all dead cat bounces. This stock market trend usually comes during a severe bear market. It’s possible that some investors believe the bottom has been reached, and so they start buying again. This increased volume causes the price to rise slightly, but it could be the stock doesn’t gain enough momentum to continue its rebound.
Another cause of a dead cat bounce could be short sellers exiting their positions. When someone takes a short position on the stock, they essentially bet against it, selling when the price is higher so they can repurchase it later for a lower price. If many short sellers repurchase their stocks at once, it causes a temporary rally in the stock’s price. However, the actions of these traders aren’t enough to fully pull the stock out of its declining trend.
Sometimes, however, there’s no identifiable cause for the dead cat bounce. The stock market naturally experiences short-term volatility, and it’s not entirely unusual for a stock that’s trending in one direction to temporarily reverse course. Instead, it’s simply the nature of the stock market.
Example of a dead cat bounce
Suppose Company ABC has a difficult year and its share price is on a long-term downward price movement. The stock’s price fell from $40 per share down to $25. Against the predictions of technical analysts, the stock makes a sudden rally, rising to $30 in a matter of weeks.
Some investors may see this price increase as a sign the stock was on the rebound, causing them to buy up shares. But the rally turns out to last for only a brief time. Within a couple more weeks, Company ABC’s stock plummets once again, reaching a new low of $22.50 per share. Unfortunately, the investors who bought the stock at $30 lose money.
Limitations of a dead cat bounce
While it can be helpful to understand how a dead cat bounce works, there are also some limitations to this market trend. First, correctly identifying a dead cat bounce in the midst of it is nearly impossible, and making a guess either way could cause an investor to lose money.
If you assume that a rally will be long-term and buy the stock, you’ll lose money when it ultimately declines again. But if you identify a rebound as a dead cat bounce when it isn’t, you could miss out on the opportunity to buy what will become a profitable stock.
In most cases, it’s only possible to identify a dead cat bounce after the fact. While technical analysis might attempt to forecast one, there’s no way to know until after it’s happened if the forecast was accurate. And once the dead cat bounce has already happened, there’s little to do with that information, since you’ve already either purchased the declining stock or missed the opportunity to do so.
Trading strategies for a dead cat bounce
A dead cat bounce can result in major losses for those who buy what appears to be a rallying stock, only to have the price fall once again. That being said, if you’re lucky enough to identify the dead cat bounce ahead of time, you may be able to profit from it.
- Sell during a dead cat bounce. If you buy a stock as it’s in its initial decline, you could profit by selling it during the dead cat bounce when the stock price is at its peak. The trick, of course, is selling at the right time.
- Short position. Short selling is a strategy where a trader borrows shares from their broker to sell while the price is at its peak. An investor might do this when their technical analysis tells them the price is going to decline again. Once the price drops, the short seller repurchases the borrowed shares for a lower price, pocketing the difference as profit.
- Stop-loss order. You can also hedge your risk against a potential continued downward trend. One way to do that is using a stop-loss order, which directs your brokerage firm to sell the stock once it dips below a certain market value.
The problem with selling a stock short is that, as with a dead cat bounce in general, it’s nearly impossible to know for sure when a stock is going to decline. And if you short a stock because you forecast a decline and then the price increases instead, your losses could be substantial.
As a result, short selling isn’t an appropriate strategy for most investors, and it should be left to experienced traders who are prepared to sustain the potential losses.
How to avoid a dead cat bounce
The good news is you don’t necessarily have to trade a dead cat bounce at all. While active traders often try to time the market and profit from its day-to-day fluctuations, many other investors play a longer game.
So how can you avoid trading a dead cat bounce altogether? Consider investing in a diversified portfolio of index mutual funds or ETFs. For example, you could track the overall market so that when the market rebounds, so does your portfolio. This strategy eliminates the need for you to pick individual stocks or choose the best time to trade.
Regardless of what strategy you use, you can save time and money by using the right brokerage. The tool below can help you compare the best brokerage for your investment style and level of experience.
How long does a dead cat bounce last?
There’s no set amount of time that a short-lived rally must last to be considered a dead cat bounce. These temporary rallies can last anywhere from months to days.
Where did the term dead cat bounce come from?
The expression dead cat bounce comes from the idea that “even a dead cat will bounce if it falls far and fast enough.”
What is the opposite of a dead cat bounce?
One might consider a bear trap to be the opposite of a dead cat bounce. While a dead cat bounce is a temporary rally for a stock that’s been trending downward, a bear trap is a temporary downturn for a stock that’s been trending upward.
- A dead cat bounce is a market trend where a stock experiences a sharp decline, a temporary recovery, and ultimately, a continuation of its downward trend.
- A dead cat bounce can be caused by a variety of factors, including traders exiting their short positions or traders simply believing the stock has reached its low.
- Unfortunately, it’s impossible to identify a dead cat bounce as it’s happening, and it can only be correctly identified after the fact.
- You can successfully navigate a dead cat bounce by selling your shares at the time, shorting a stock during the bounce, or simply focusing on a long-term strategy.
Find the best brokerage for you
A dead cat bounce is described as a temporary rally for a stock that has been in a prolonged decline. Unfortunately, a dead cat bounce can mislead investors, and even cause them to buy stock in a company they think is on the rebound, only to lose money when the stock price once again declines.
A dead cat bounce will be most impactful for active traders and those trying to time the market. However, every investor should understand how they work. If you’re in the market for the perfect brokerage firm for your trading, we can help. We’ve rounded up a list of the top brokerage firms, along with reviews, fees, available assets, and more.
View Article Sources
- Dead Cat Bounce — CMT Association
- Stock Purchases and Sales: Long and Short — U.S. Securities and Exchange Commission
- How To Invest In The Stock Market: 8 Basic Concepts — SuperMoney
- Best Online Brokers for Stock Trading in 2022 — SuperMoney
- Best Stock Trading Apps in 2022 — SuperMoney
- Brokerages: Reviews & Comparisons — SuperMoney