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Day Trading Techniques: Dead Cat Bounce

Day Trading Techniques: Dead Cat Bounce
March 20
20:04 2012

Day traders and short-term traders are constantly seeking techniques that exploit certain predictable patterns in equity price movements. One such technique is the dead cat bounce.

The colorful name for this phenomenon reportedly dates from 1985, when a Financial Times journalist quoted a stock broker who was discussing a brief respite in the brutal Singaporean and Malaysian bear markets. The technique seeks to exploit the brief reversal of a strong downward price movement. It occurs when a stock in virtual free-fall generates a tremendous amount of short interest. At that point, the least suggestion of a rally will produce a rash of short-covering, which drives the price up very strongly—but just as temporarily. Since the stock’s weakness is usually justified by fundamentals, once the excess shorts are cleared, the price will continue its fall.

Probably the single greatest challenge with the dead cat bounce is determining when to enter a long position. Move too soon and you risk entering above the price at which the dead cat bounce will terminate—meaning the continued fall between the time you buy and the time the bounce peaks will wipe out your potential profits. The key indicator is a noticeable surge in volume which will precede and accompany the bounce. (This is produced by the short-covering activity.)

The lead-up to a dead cat bounce can vary. In some cases the bounce follows a prolonged decline. For an example, look at a chart of price and volume for Fannie Mae (FNMA) from August 1, 2008 to September 1, 2009. Note the bounce in late March 2009 (and the volume spike that accompanied it) after the stock began falling in October 2008.

In other cases, a sudden instance of bad news may cause a stock to gap downward suddenly. For an example of this instance, look at Amazon (AMZN) from June 1, 2001 to October 1, 2001. When the company unexpectedly missed earnings, its stock fell precipitously on July 23, to be followed by a mild bounce and further extensive decline.

On average the total decline is 31% over a seven-day period, which is the average duration. The average bounce is 28% within 23 days, though it can happen much more quickly in some cases. Price gaps are easy to identify, but in the absence of one, the best key to identifying a coming bounce is the volume indicator (seen mostly clearly in the FNMA example).

Of stocks that experience a dead cat bounce, 26% will experience a second bounce within 90 days and 38% will experience one within 180 days. Again, FNMA is an excellent illustration of this, with a second (but much smaller) bounce occurring in early July 2009 on a tremendous volume spike.

Since timing a dead cat bounce can be tricky, you may choose instead to let the bounce play out and then short the stock for the coming decline. You may also play the bounce and then immediately exit into a short position to profit twice from the movement.

For safety, use limit orders to automatically exit the position once the stock price has achieved a predetermined upward movement in percentage terms. Since the average bounce is 28%, you may set a limit at 25% (for example), but 28% is an average—not every stock will bounce that high. Watch your position carefully, and as soon as weakness appears, exit. (You need only examine both the FNMA and AMZN examples to see how quickly the bounce dissipates.) Bear in mind that day trading and short-term trading require discipline to be successful. Don’t let greed tempt you into remaining in a position too long, or you may find yourself losing all of your gains and more.

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