Spotting a Dead Cat Bounce… Yes You Read That Right
Why yes, Dead Cat Bounce is the name of a rock band … but that’s not the topic of conversation today.
In the context of the stock market, a dead cat bounce is a specific type of stock chart pattern phenomenon occurring in downward trending stocks. That’s what we’re talking about today.
While a down-trending market can be a real bummer, there are certain opportunities that this pattern can offer, particularly for short sellers.
Here, you’ll get schooled on the dead cat bounce pattern, including what it is, how to spot it, and tips for how you can use it when seeking out potential trades.
What Is The Dead Cat Bounce Pattern?
Perhaps one of the most memorably-named stock chart patterns, a dead cat bounce refers to a specific chart pattern where the stock’s price has a big drop, followed by a brief recovery (or “bounce”) before the descent continues.
The funny name has been actively used since the 1980s, when Asian markets were falling hard, then had a brief recovery before continuing an ailing trajectory.
This phenomenon was called a dead cat bounce, going from the adage that “even a dead cat will bounce.”
It was undoubtedly a catchy phrase, so it didn’t take long for the concept to catch on. Now, the dead cat bounce can refer to this sort of action in stocks, forex, commodities, and even beyond the financial sphere.
Benefits of Trading The Dead Cat Bounce Pattern
The dead cat bounce might sound like a real downer, but there are plenty of benefits it can offer, including:
- A helpful indicator. A dead cat bounce can be an indicator of market weakness, either in the market at large, or within a certain sector. While nobody likes to see things go downhill in the economy, it’s good to know what you’re up against in the market, because this allows you to create the most effective trading strategies.
- High volatility. Day traders love volatility. Well, maybe not love it, but they recognize that volatility can cause the spikes that they’re hoping can help them generate profits. A dead cat bounce can be a big short term spike, so as a day trader, you could benefit from this phenomenon.
- Opportunities to buy low. It’s possible to benefit from a dead cat bounce by buying shares when the stock hits a low point and then unloading them during the bounce. However, it’s important to keep in mind that it can be very hard to determine if it’s a dead cat bounce or if it’s a trend reversal.
- Opportunities for short sellers. If you’ve done good technical analysis and determined that a stock is experiencing the dead cat bounce pattern and not a trend reversal, it could be a good time to get into a short-selling position. If the price continues to go down, there could be a potential to profit.
- It can repeat. Sometimes, a dead cat can bounce more than once. If you look at a stock’s chart, you may notice that there are bounces at regular intervals. If so, it could be a pattern worth looking at, because it could repeat again.
How The Dead Cat Bounce Pattern Occurs
So you know that the dead cat bounce is characterized by a stock taking a dive, bouncing back, and then continuing to lose momentum. But what causes it, and how does it play out?
Consider a stock that has been slowly but steadily declining for a few weeks in a row.
Short traders are seeing the decline and beginning to think, “maybe I should exit here and take my profits”.
At the same time, the trade can become enticing for people looking for a good value. This could cause a flurry of buying activity.
You could think of it like a pressure system that you’d see on the Weather Channel. When these two things happen at the same time, they create a pressure that causes the perfect storm, briefly making the stock spike.
However, the pressure is unsustainable, and after the flurry of activity, the downward crash continues.
This is a pattern that we’ve seen play out over and over throughout the years. For instance, during the dot-com crash in the early 2000s, there was a brief rally in stock prices before the downward spiral continued.
Ultimately, uncertainty is what causes a dead cat bounce.
When the long downward direction goes on, some traders will think the market has reached the bottom, which spurs activity for both long and short buyers.
Examples of How to Spot a Dead Cat Bounce Pattern
To really bring these concepts home, let’s look at some specific examples of dead cat bounce patterns. These are from StocksToTrade.
#1: India Globalization Capital, Inc. (IGCC)
India Globalization Capital, Inc., is a company involved in creating and commercializing cannabis products to help treat medical conditions.
In recent months, while shares have largely been trending down, they have experienced a few bounces that could be classified as dead cat bounces.
This can be evidenced by quick, violent spikes in price that are rarely sustainable.
#2 Achieve Life Sciences Inc (ACHV)
This specialty pharmaceutical operation works with medications meant to help people quit smoking.
Last year, following positive results of a clinical study, the share price skyrocketed, but quickly declined, with several bounces along the way.
With biotech companies, news catalysts can be extremely fickle and short-lived. It’s very important to stay on top of clinical trials, the results, and to keep an eye on the company’s balance sheet.
#3 Zosano Pharma Corporation (ZSAN)
Zosano Pharma Corporation is a pharmaceutical company involved in the development of a proprietary dermally applied microneedle drug delivery system to treat migraines.
Last year, they had a reverse split, which caused a decline in price. However, there was one big bounce last year, and another just recently.
Reverse splits can often cause a decline in stock price.
In case you’re not familiar, a reverse split is the opposite of a traditional stock split. It’s usually performed by companies with low share prices. The reverse split will actually increase the share price, but reduce the overall amount of shares available.
So, if a company does a 4-for-1 reverse split, if they have 4 million shares outstanding with a price of $1 per share, they would now only have 1 million shares outstanding with a price of $4 per share.
The split itself doesn’t change the value of the company, and the dollar amount of the total shares remains the same.
Often, companies perform a reverse split because they are trying to avoid being delisted from an exchange because of the low share price. This isn’t always the case, though; sometimes they want to increase the share price to make the jump to a larger exchange.
Why would a reverse split affect a company negatively? Because it can look like a big red flag to traders, particularly if the shares have been waning recently.
However, the descent isn’t always without a few bounces. Sometimes a spike can occur that can create opportunities for traders.
The Bottom Line
Downward trending markets and stocks usually aren’t something that get traders excited. But there are ways of successfully trading these stock plays with a responsible approach.
Interested in trying your hand at stock plays using the dead cat bounce pattern?
In order to do that properly, it may require you to increase your general knowledge of the stock market itself.
In tomorrow’s issue, we will review some key tips and what to avoid when using the dead cat bounce pattern as a trading tool.
— Tim Sykes
Editor, Penny Stock Millionaires