Sometimes chart patterns and plays have funny names or slogans. The Dead Cat Bounce is definitely up there with the strangest. What is a Dead Cat Bounce and why would anyone point to a stock chart and say, “Hey look at that dead cat bounce right there!”
The Dead Cat Bounce play is based off the old saying that even a dead cat can bounce if it falls hard enough. But how does this apply to stocks? It’s actually quite simple. It means a stock has dropped in price significantly closing on a low and opening again with a higher entry then the previous close.
A Dead Cat Bounce signal is quite easy to spot on a candle chart. Simply look for the giant bearish candle. These signals can and often occur around earnings reports or other catalysts. Instead of continuing the downtrend a Dead Cat Bounce will occur and the stock will pick back up and start trading above where it last closed. This dip creates an amazing opportunity for traders looking to get in and scalp some quick profit.
Here is a great example of what this looks like on a chart:
As you can see from the chart above the long bearish candle closes much lower than where it opened. The following candles open significantly higher from that close. If the trader enters the trade right after that second candle they may think a bullish uptrend is about to occur. There would have been a few days of questioning that play but eventually, a couple weeks later, it would have paid off nicely.
Depending on the stock and the confidence you have in that particular security the dead cat bounce can be a great opportunity for longs to get into a position with some cheap shares. It’s important to combine as many technical indicators as possible. If the play occurs around earnings then do some due diligence and divert your attention to the fundamentals of the security to see why the earnings performed so badly. This can help you decide if this stock will be a good one to profit from or not.
Here is an example below of a much weaker Dead Cat Bounce. As we see the stock had a hard drop and hasn't quite made it back to the original trading levels it was once at before the hard drop. This would have been a tricky one to play because the buyers trading on this specific pattern would likely have bought in at that third candle after the bounce. While, there was a little bit of room for profit we can see theres a dip coming.
These plays must be carefully thought out and before purchasing anything it is the traders responsibility to make sure they understand why the stock dropped in hopes of understanding whether or not it can continue to increase. A lot of times we see a hard drop on earnings. We want to be careful trading around earnings as the price can typically continue to trend downwards.