Last Updated on October 1, 2023
In finance and investing, peculiar terminologies are often used to describe unique market phenomena. One such example is the term “Dead Cat Bounce.”
This enigmatic expression is widely acknowledged for its intriguing name. However, it holds a significant meaning for traders and investors looking for ways to navigate volatile market periods.
This article will demystify the Dead Cat Bounce effect by exploring its meaning and explaining how to spot it.
Dead Cat Bounce Meaning
Dead Cat Bounce refers to a temporary recovery in the price of an asset after a long decline. It also implies that the initial decline is legitimate and that there is a reasonable expectation that the price will keep declining after the temporary bounce.
In other words, the turnaround shown by the bounce is temporary. This makes the “Dead Cat Bounce” a phrase that is more applicable when describing past price movements rather than predicting future ones.
A similar phrase used in cases like this is a “Sucker Rally.” Based on the presumption that the downward trend is reliable, investors would be suckers to buy in after seeing a Dead Cat Bounce, presumably because the price decline is likely to continue.
Origin of the Dead Cat Bounce
The term’s first use occurred in 1985 when the stock markets in Malaysia and Singapore were experiencing a recession.
A pair of Financial Times journalists, Wong Sulong and Horace Brag, reviewed the market when it experienced a slight uptick after a continuous decline. Their work described how the price moved as a “Dead Cat Bounce.” The idea behind this phrase is that even a dead cat will bounce if you drop it from high enough.
How Do You Spot a Dead Cat Bounce?
Here is how you can identify the Dead Cat Bounce:
Study Past Patterns
Although there is always a variation from one Dead Cat Bounce to another, patterns remain the same even if stocks and companies change. When you see repeating patterns, you will start identifying them.
Look for a Significant Decline
Try to identify if there are significant and sharp declines in the price of an asset or security. This is the starting point for identifying a potential Dead Cat Bounce.
Temporary Recovery
After the substantial and sharp decline, look out for a temporary and quick recovery in the price. The rebound is usually brief compared to the magnitude of its initial drop.
What Are the Causes of a Dead Cat Bounce?
Here are some of the causes of a Dead Cat Bounce:
Speculative Trading
After a substantial decline in the price of an asset, some investors may speculate that the asset’s price has reached its bottom, which may lead them to buy at what they see as a bargain level. This speculative buying can drive up the price temporarily, which consequently creates a bounce.
Clearing of Short Positions
Investors who sold an asset short initially because they anticipated a price drop may reverse their positions and buy again to cover their shorts. This activity contributes to the temporary price recovery during the bounce.
Pursuit of Oversold Assets
Some traders actively look for oversold assets after a substantial decline because they believe they present good buying opportunities. This can lead to a short-term uptick in the price, which causes the Dead Cat Bounce effect.
Market Manipulation
Market manipulations can also cause the Dead Cat Bounce Effect. Some traders may create this effect by placing large orders to give an illusion of a recovery. But once the bounce occurs, they usually start selling, leading to another price drop.
Dead Cat Bounce Example
Assume that the stock of ABC Company is trading at $100 per share. However, it then dips to $30 per share. After reaching this point, many investors start considering it undervalued and decide to buy. This causes a sudden bounce and the price increases to $45 per share. However, this effect is just temporary and, after it passes, the stock price declines again to $30 per share, confirming the Dead Cat Bounce effect.
How Long Does a Dead Cat Bounce Last?
Dead Cat Bounce is typically a temporary phenomenon and its duration varies anywhere from a few days to a few weeks. However, sometimes, it can extend to a few months.
What Are the Limitations in Identifying a Dead Cat Bounce?
A Dead Cat Bounce can usually only be spotted after it happens. This means that when there is a steep decline, traders may assume it is a Dead Cat Bounce effect, whereas it is a reversal in trend leading to a prolonged bullish rally.
Tips for Trading a Dead Cat Bounce
Here are some tips to make the most out of a Dead Cat Bounce:
- Don’t risk too much capital;
- Identify the right time to sell;
- Lock in your profits early and don’t hold for too long;
- Place a stop loss to cut your losses if the market turns against you.
You may also like: Trading Risk Management – Best Strategies to Help Reduce Losses
Conclusion
Traders looking to capitalize on Dead Cat Bounces should have patience and act with precision. While its identification may have limitations, recognizing past patterns and significant declines can be helpful. However, exercise caution, and avoid trading significant capital to avoid massive losses.
