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Trading Techniques: Inverted Dead Cat Bounce

Trading Techniques: Inverted Dead Cat Bounce
March 29
17:48 2012

We have recently discussed the “dead cat bounce,” a trading technique that exploits the brief reversal of a strong downward price trend. You may not be surprised to learn that there is an inverse version of the dead cat bounce. This technique is intended mostly for use in monitoring your existing stock holdings, though after the initial bounce it is possible to make further trading plays in stocks you do not own.

What essentially occurs is that the stock jumps—in many cases gaps—upward suddenly, usually on unexpected good news. Because there is little fundamental underpinning for this jump, the lack of sustained support combined with profit-taking by short-term traders sends the stock back down in short order over a period of several days.

A coming inverted dead cat bounce is signaled by a price spike of at least 5%, though 20% and even 50% or more are not unheard of. This normally occurs on the day following the news announcement. In every case, you will sell the day after the initial rise if you already own the stock. After that, or if you did not own it, the further handling of the trade will be dictated by the amount of the increase, which is measured based on the percentage change from the session before the spike to the close on the day of the spike.

  • For a 5% increase, enter (or reenter) a long position in the stock in week 2; the price should rise through week 4.
  • For a 10% increase, do not enter a long position—the price is likely to continue downward. Leave this one alone for long trades, although shorting is an option.
  • For a 15% increase, you should see a bottom by the third day. Enter a long position and maintain it until week 4.
  • For a 20% increase, the bottoms should occur on days 3 and 11. Enter a long position on either day and maintain it until early in week 2 or week 4. You should expect to see a downturn late in week 4.

Note that price spikes resulting from merger and acquisition rumors are best avoided with this technique, because in these cases the stock will tend to either stay near the new price or move even higher rather than declining.

As an example, we’ll consider 3D Systems Corp. (DDD). On February 23 and 24, it gapped upward over two days, from a February 22 close of $20.93 to a February 24 price of $24.15. Selling on either February 24 or February 27 (the next session) would have netted a respectable profit, as the stock closed at $24.52 on the 27th.  The shares then began declining. On March 6, the beginning of week 2, the stock bottomed at $21.71. It remained flat, then began climbing in the middle of week 3 and has continued to rise through week 4.

Beyond week 4, the pattern’s predictability wanes, so you will need to monitor news and fundamentals, look for the emergence of a new technical pattern, or exit your position and take profits. (Since this technique is aimed first and foremost at handling a stock you already own, if you had a reason for holding it prior to the inverted dead cat bounce, you may wish to remain in a long position.)

In any event, 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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