Dead cat bounce: All you need to know about this golden opportunity

As per the theory, a dead cat bounce is a continuation pattern where the bounce is expected to hit strong resistances and re-join the earlier downward trend.  A dead cat bounce, thus, is believed to be short-lived. The name “Dead Cat bounce” is based on the notion that even a dead cat will bounce, if it falls far or falls with a high speed.

However, it has been observed, especially in recent times, that a dead cat bounce often leads to a firm reversal, on the back of follow-up buying.

Implications:

-- Although, a dead cat bounce suggests that more weakness is likely to emerge in the near term, a strong sustained reversal with increased volumes may dismiss that view.

-- If the markets reflect addition of interest by market participants with rise in follow-up buying, the continuation pattern may not hold ground any further.

-- A dead cat bounce can also be seen as traders closing their short positions and waiting for better opportunities to enter on the short recovery.

-- Whenever the bounce fails to hold the support of the follow-up buying, it is wise to liquid one's positions and stay on the side-lines.

-- A dead cat bounce may be very effective when accompanied by a positive development in the economy.

How to identify:

-- A gap-up opening with stock prices scaling higher highs in intraday.

-- A firm gap-up close of over 2 – 3 per cent on the indices.

-- The stock / index shows a reversal close to the Fibonacci retracement, moving averages, or trendline supports.

-- A continuous weakness with persistent negative sentiment may see some unforeseen recovery.

-- Markets are constantly trading in oversold territory of respective technical indicators.

Market reversal vs dead cat bounce

Market reversal and dead cat bounce are two distinct events which, in certain cases, may even support and accompany each other. A dead cat bounce may lead to a robust reversal. That said, even if a dead cat bounce doesn't turn into a market reversal, it still provides short-term relief with expectation that stability may emerge in coming sessions.

Investors consider the dead cat bounce as the first signs of stability and upon confirmation of the reversal, they may consider adding the stock to their portfolios.

How to trade?

The low of the dead cat bounce becomes the crucial support for next sessions. Till this support is held, the upside bias may see added interest. Upon breaching the said support, the sentiment may gain more aggression on the continuation pattern and more downside is anticipated.

A dead cat bounce is a golden opportunity for a day trader. If identified on time, one can profit from the structure's strong moves.  This, in turn, helps build confidence despite the overall negative sentiment. Similarly, a short trader can maximize returns by liquidating positions and staying on the sidelines. CLICK HERE FOR THE CHART