Dead cat bounce is very popular term in stock trading and used frequently for long term down trended stocks or indexes which are trying to bounce back to uptrend. This term used because at the beginnings of the upward move traders are uncertain whether this rally is a short term short covering by short seller or the beginnings of new upward movement of the stocks or indexes.
What is a Dead cat bounce:
Dead cat bounce is an event driven stock trading strategy that occurs due to sudden news or major event of stock which moved the stock quickly with heavy volume. Stock usually move down by a gap and price changed at least 15 to 20 percent. Sometimes price could be changed as high as 90 percent.
Dead cat bounce happens when stock is already down too much and short sellers started to cover their position after stock heat a certain level. Since short sellers are buying stocks to cover their positions and some value investors also buying because of low price of the stock, stock price started to move up and stock have a quick short rally to a certain point. From technical analysis, this rally should be up to 50 percent from recent downward move.
Reason for Dead Cat Bounce Happen:
Several reasons for Dead Cat bounce are mentioned below:
- Missed earning Consensus or EPS by big margin
- FDA approval for drug companies
- Acquisition of a company
- Securities Exchange Commission (SEC) inquiry of a company
- Merger deal with other company
- Takeover a rival company
- Scandal or misappropriation report of a company.(Enron)
- Lose of market share to rival company
- Company will be affected by government new initiative(Obama Care for Health Care provider companies)
Pattern Recognition of Dead Cat Bounce:
Dead cat bounce trading pattern is very easy to find out and traders can decide whether to enter in dead cat bounce trade or not. Some sign of dead cat bounce are:
- Stock should gap down as major event triggered.
- Gap should be at least 15 percent of the stock. Gap could as high as 70 percent.However, Gap is not necessary condition. Sometimes event occurred at the middle of the trading day and stock slide down sharply without gap. In this case stock has no option of gap down that day.
- Volume should be higher in the stock gaping day.people become scared after the news or event and try to get off from the position. One group of traders try to take advantage by shorting the stock after the event triggered. That’s why volume increased the event day.
- As stock started to bounce against the stock gaping direction, volume should not peak up like gaping day.
- Stock should bounce between 50 to 62 percent range of original gaping range to have a valid set up for stock trading. A lot of the time as stock bounced more than 62 percent against the existing, trend becomes weak and sometimes trend reversal occurs because of that.
Target Price for Dead cat bounce :
Target for this trade setup is 100 percent from the entry price of 50 to 62 percentile to 161 percentile in Fibonacci measurement.
Trade setup for Dead Cat Bounce:
OCN gaped down because of its missed Second Quarter earnings in 2014. In two days stock was down more than 20 percent. That a good set up for dead cat bounce trade. Stock came down from $35 to $25 and get support at $25. Now we are watching for the stock bounce and how volume is formed during the pull back and sharpness of the bounce. We watched stock made a gravestone doji pattern right at the 50 percent pull back.
That’s a signal that stock is possibly heading toward gap down direction again. Stock tried to move up again and came all the way to 50 percent level again and eventually closed above the Fibonacci 50 percent level and strong closed. Next day strong gaped up but failed to hold its position. Stock started to move down, engulf and closed below the previous day green day. Second day red candle formed a bearish engulfing pattern with above average volume. This is a confirmation signal for entering the trade.
Entry to the Dead Cat Bounce trade:
Stock trader should enter the trade after bearish engulfing pattern is formed. Entry price should be below27.89, low of the bearish engulfing pattern low red candle. Best is if red bar had above average volume. Trader should hold position until stock reach to 161.8 percent of Fibonacci retracement level. In the OCN chart, Stock heat 162 percent with big red candle and above average volume. Trader should leave the position as price heat the $19. Entry of this trade is indicated by blue line.
Exit the trade or Stop loss:
This stock trade has three potential stops or exit.
Exit 1: First stop loss or exit should be $29.28 or above that price because this is high of bearish engulfing pattern. If stock breach this price, stock is heading toward another Fibonacci point like 62 percentile or high price of the gap. This is very tight stop for the stock. Yellow arrow of Exit 1 is the stop loss of the trader. Trader should use this stop for stock trading if he highly conservative or have low conviction about the trade.
Exit 2: Second exit price is 32.50 or above the highest price of the Gaping day candle. Yellow arrow of exit 2 is indicated the second exit or stop loss of the stock. Opening of the gap itself becomes a resistance area and sometimes indicates price reversal of the stocks.
Exit 3: Third exit is top of the gap or indicated by yellow arrow of Exit 3. This is the most wide stop loss and possibility that stock will not bounce back in that price if this is real dead cat bounce pattern. If stock breached this stop loss, trader should leave the trade as dead cat bounce pattern is completely broken.
Bottom line: Dead cat bounce is highly popular as bearish stock trading strategy for already down trended stock. This pattern is very easy to identify and trader needs to understand there are not trapped in other side of the move. However, this trading strategy should be used in combination with other technical analysis indicator for reliable result.