How to Trade a “Dead Cat Bounce” (Part 2)

11/04/2009 12:01 am EST

Focus: STRATEGIES

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

Identifying a dead cat bounce is just part of the challenge. Estimating or forecasting the likely distance the stock will move following the pattern's confirmation is also important. This is a challenge for technical analysts as much as it is for fundamental analysts. Creating an estimated profit target will help you make better decisions about the trading strategy you will use to take advantage of the price move.

There is a reasonably easy way to start making these estimates following the bounce back down from resistance. To do this, we will be using Fibonacci retracements, which are one of the primary tools used by technicians to identify support and resistance levels and to make price projections. The same technique you see in this article can be applied on many other technical patterns as well.

The image below illustrates how this analysis is conducted. A Fibonacci retracement is drawn from the first bottom following the gap (point A) to the break down from resistance at the gap (point B). The retracement lines themselves can be ignored because what you are interested in is past the first low at the 161.8% projection level (point C).

chart
Click to Enlarge

As you can see in the case study above, this price was easily reached. Of course, ongoing trade management continues to be important, but this analysis provides a solid starting point for evaluating the opportunity.

Based on the estimate, you can decide how to best take advantage of the opportunity. A very tight profit target may be difficult to trade with a long option, and a short call sold above resistance may be more attractive. Conversely, a very long profit target could be ideal for a long option that retains unlimited profit potential.

Trading a technical price pattern is a three-step process. First, we identify the pattern and wait for confirmation. Second, an initial price target estimate is produced. Third, using the information gathered in the first two steps, you can select the right trade strategy and actively manage the position. Approaching an opportunity this way helps traders maximize a profit opportunity.

Watch the video now for more details:

By John Jagerson of LearningMarkets.com

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