swing trading, online trading

Dead Cat Bounce begins at gap down (only down gaps apply), either from news, be it corporate or economic. This pattern appears more often around quarterly earnings reports. This is especially common among the pharmaceuticals where there is the highest numbers of these Dead Cat Bounces. In addition to corporate, their drugs and products are at the mercy of the application to the FDA. Their negative results cause these bursts of price volatility.

What is a Dead Cat Bounce? The characteristics of the pattern are:

1. Down gap of at least 20% on unusually high volume, at least 3-4 times the daily average. The average drop for this pattern is between 30-40%. The bigger the gap, the bigger the possible bounce. But there is more downside to come more often the larger the gap.
2. The price drops then followed by a bounce, anywhere from the following day to the next few days. If the bounce doesn’t come within a week, but continue going down. The bounce will likely to be small, if there is ever one coming.
3. Prices may reach to where the gap began but does not go higher than that price range. When prices do bounce, the expected price target is usually where the day before the down gap began. Most bounces will not make that far. But for those that do, they will usually reverse and start downward again.
4. Duration of the downtrend may continue from 3 to 6 months, depending on the stock and the market condition. The average is usually an additional 15-25% price drop.
5. The location of where the drop relative to the market is important to determine if the pattern’s likelihood to fail or not. If the drop occurs near the stocks’ long term high, then the drop will be greater and the failure rate is smaller. This usually occurs near the end of the bull market where companies are beginning to announce disappointing earnings, etc. If the gaps occur at the long-time low, then the likelihood of the failure is high. This happens toward the end of the bear market, where so much bad news had happened already that there are no more sellers out there to dump their shares into the market. This gap down is possible the bears’ final gasp before the small number of buyers push the market up again.
 

Figure 1 Typical Dead Cat Bounce characteristics: gap down on high volume, small bounce, and downward move.

The chart above shows the typical action of the Dead Cat Bounce. Prices opened down with a big gap. The day with a wide range but despite the wide high/low action, the day ended undecided as high volume. The next few days, the market continued in the same direction. Finally a small push up, a bounce, but lasted only a few days before it is pushed down again.

Figure 2 - Dead Cat Bounce failure.

Figure 2 shows the pattern failure, where the bounce was timid compared to the colossal size of the gap. But after a week of consolidation, prices gapped up and continued upwards, breaking above the first bounce, encouraging more bulls to join in the action.

How does one trade this pattern? NEVER look for a LONG trade, only a short trade. After the gap down, there are two useful pieces of information that must be noted before deciding on an entry: finding the resistance areas, that is, the top of the gap and the bottom of the gap. This usually presents the area where a big number of buyers and sellers have acted and these same participants will act again when these price levels are touched again. The chart below shows the resistance area at the bottom of the gap. This level was tested three times and failed to make above that level.

Figure 3- The bottom of the gap showing strong resistance.

The chart above illustrates the strength of the resistance. In this instance, the bottom of the gap was the important level to keep prices down.