How to Trade a "Dead Cat Bounce" (Part 1)

11/03/2009 12:01 am EST

Focus: STRATEGIES

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

Extremely volatile markets create an environment for the formation of a very specific type of technical price pattern. The "Dead Cat Bounce" pattern (DCB) may have a macabre name, but it comes with very nice profit potential and is relatively easy to identify.

At its heart, the DCB is a great study in investor psychology. It occurs when investors have panicked or have been caught by surprise, which is why the pattern occurs most frequently in bearish and volatile markets.

Investor psychology comes into play because traders are likely to become fearful at the same price levels that they have been fearful before. We use the DCB to identify those price levels for potential breakouts.

The pattern consists of a gap during a downtrend when prices have moved between the close of one day and the open of the next trading day. The larger the gap, the more significance technicians will assign to the pattern. The gap is typically created by unexpected news appearing after or before normal market hours.

The gaps indicates that traders have "overreacted" to the data, and the stock is likely to become oversold at some point and will begin to retrace back towards the gap. The top and bottom of the gap will act as resistance barriers and if the market or stock peels off of these resistance levels, the subsequent decline can be quite significant.

The rally back towards the gap is a good example of a bull trap and the final decline that completes the pattern can be large and fast as a feedback loop of stop losses push more sellers into the market.

Example of a Dead Cat Bounce

chart
Click to Enlarge

In the chart above, you can see a DCB that formed on Goldman Sachs (GS). Once a breakout to the downside occurs, shorts enter the market. Buying puts at this point is a great way to limit your risk while still taking advantage of the downside potential.

In the video, I will cover the pattern in more detail with a few additional examples. In the next article in this series, I will show you how you can project price targets once the pattern has completed itself.

Watch the video now:

By John Jagerson of LearningMarkets.com

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