In a recent post, we defined what the “Dead cat bounce” phenomenon is. In short, it is a term used when a market manages to muster a temporary rebound within a prolonged period of downside. A dead cat bounce is typically considered a price pattern, while it can also be explained as the repositioning of market participants, by closing short positions to lock profits, on the assumption that market has reached its bottom. Hence they then flip to the long side of the market, on the belief that the market is oversold and it’s time to move up.

USA500

In this post we will now elaborate how to trade this phenomenon. However before we go through the “dead cat bounce” strategy, we need to once again  highlight that a dead cat bounce can be seen both in the broader economy, such as during the depths of a recession, or it can be seen in the price of an individual stock or group of stocks. However it is difficult to predict beforehand.

 

Is it possible to trade it?

Generally, in the market, like in physics, there is the view that every action has a reaction, hence every sharp move will have a correction. That means market participants are confident that an uptrend could turn back after decline. However, the mentality of a dead cat bounce pattern is the exact opposite. The mentality here is that every steep sharp decline could see a temporary recovery before extending further lower again. An example is the USA500 in March.

This 4-hour chart, between November 2019 up to February 2020, clearly presents the “buying the dip” mentality, since bulls have taken advantage of every pullback, e.g. December 2nd, January 6, January 30 and many more.

USA500

However, in a period of long sustained decline, the market changes its perceptions. In a period of an extended bear market, any swing lower is the harbinger for further collapse, while any swing higher are usually fading, on market participants’ perception that they will not last for long. The only tool that could help traders identify whether this might be a dead cat bounce or a trend reversal, is the Fibonacci retracement indicator.

USA500

Theoretically, any rebound after a sharp long-lived decline, with less than 38.2% losses’ retracement, suggests that this is a shallow retracement and therefore is simply a dead cat bounce. This shallow rebound presents market assumption that there isn’t enough confidence in any rebound. There are always exceptions though, with a dead cat bounce confirmed on March 5, which reached 50% retracement before entering a free fall market again.

USA500

Hence when a dead cat bounce has been identified, it is crucial to monitor the market and to look for a breakout of the latest low level. Such a breakout would suggest the continuation of the downtrend. A confirmed close of the session below the latest low could also be the entry level for a short position with a tight stop loss, which could provide a high risk and reward profile. That said, stop loss should be placed at a sufficient level based on asset volatility and on the level of rebound. It is important to confirm the dead cat bounce before entering the market and to place stop losses above the peak of the dead cat bounce rather than at the peak, given that a higher high would be needed to negate the bearish view.

Disclaimer: Nothing in this communication contains, or should be considered as containing, an investment advice or an investment recommendation or a solicitation for the purpose of purchase or sale of any financial instrument.

Education feed

Editors’ Picks

EUR/USD tops 1.12 amid risk-on mood, ahead of data

EUR/USD is trading around 1.12, the highest since March. The safe-haven dollar is weakening amid optimism for reopening and stimulus, shrugging off civil unrest. EZ Services PMIs beat estimates. ADP's jobs report is eyed.

EUR/USD News

GBP/USD retraces gains under 1.2600, Brexit, US data eyed

GBP/USD consolidates the latest gains just around 1.26 amid dollar weakness. The Brexit impasse continues despite hopes for mutual concessions. Markit's Final Services PMI beat expectations with 29 points, still reflecting deep contraction.

GBP/USD News

USD/JPY consolidates near 2-month tops, just above mid-108.00s

USD/JPY struggled to capitalize on the early uptick amid sustained USD selling bias. The upbeat mood undermined the safe-haven JPY and helped limit deeper losses. Investors now look forward to the US macro releases for some meaningful impetus.

USD/JPY News

Editors’ Picks

EUR/USD tops 1.12 amid risk-on mood, ahead of data

EUR/USD is trading around 1.12, the highest since March. The safe-haven dollar is weakening amid optimism for reopening and stimulus, shrugging off civil unrest. EZ Services PMIs beat estimates. ADP's jobs report is eyed.

EUR/USD News

GBP/USD retraces gains under 1.2600, Brexit, US data eyed

GBP/USD consolidates the latest gains just around 1.26 amid dollar weakness. The Brexit impasse continues despite hopes for mutual concessions. Markit's Final Services PMI beat expectations with 29 points, still reflecting deep contraction.

GBP/USD News

USD/JPY consolidates near 2-month tops, just above mid-108.00s

USD/JPY struggled to capitalize on the early uptick amid sustained USD selling bias. The upbeat mood undermined the safe-haven JPY and helped limit deeper losses. Investors now look forward to the US macro releases for some meaningful impetus.

USD/JPY News

Crypto market stays strong despite yesterday's sell-off

Once the storm has passed, the real effects are zero at the technical analysis level. The impact on sentiment has been great and returns the market to a neutral level. The market is still in a phase of accumulation, according to a well-known quantitative analyst.

Read more

Gold: Prints rounding top on 4-hour chart above $1,700

Gold stays mildly offered after stepping back from $1,745. Considering the bullion’s moderate pullback since the week’s start, a potential rounding top bearish formation appears on the 4-hour chart. An ascending trend line from April 21 is on the bears’ radars.

Gold News

RECOMMENDED LESSONS

7 Ways to Avoid Forex Scams

The forex industry is recently seeing more and more scams. Here are 7 ways to avoid losing your money in such scams: Forex scams are becoming frequent. Michael Greenberg reports on luxurious expenses, including a submarine bought from the money taken from forex traders. Here’s another report of a forex fraud. So, how can we avoid falling in such forex scams?

What Are the 10 Fatal Mistakes Traders Make

Trading is exciting. Trading is hard. Trading is extremely hard. Some say that it takes more than 10,000 hours to master. Others believe that trading is the way to quick riches. They might be both wrong. What is important to know that no matter how experienced you are, mistakes will be part of the trading process.

Strategy

Money Management

Psychology