Trading Strategy: Dead Cat Bounce
In trading, it is common for certain types of market behavior to be referred to by specific animal types or traits. In this article, you will learn about the dead cat bounce.
What is a dead cat bounce?
A dead cat bounce is a temporary recovery in the price of a downward-trending asset after a significant drop. The term "dead cat" refers to the idea that even a dead cat will bounce if it falls from a high enough height and is used to suggest that the recovery is only temporary and not indicative of a change in trend.
The concept of a "dead cat bounce" revolves around the common belief amongst analysts that markets tend to overreact to news and events, leading to exaggerated price movements. When the price of an asset drops significantly, it may attract bargain hunters and value investors who see the drop as an opportunity to buy at a discounted price. This can lead to a temporary recovery in the price as the buyers push it back up. However, if the underlying fundamentals of the asset have not changed, the recovery is likely to be short-lived, and the price may resume its downward trend.
How to recognize a dead cat bounce?
Dead cat bounces can occur in any market and can be difficult to identify, as they can often be mistaken for genuine reversals. However, there are a few signs that may indicate a dead cat bounce is occurring:
Sharp drop: A sharp drop in the price of an asset is often a sign that a dead cat bounce may follow. This is because the sharp drop may attract value investors and bargain hunters who are looking to buy at a discounted price.
Lack of fundamental changes: If the underlying fundamentals of the asset have not changed, it is more likely that the recovery is a dead cat bounce and not a genuine reversal. For example, if a company's earnings and financials have not improved, it is unlikely that a recovery in its stock price is sustainable.
Short-lived recovery: A dead cat bounce is typically a short-lived recovery, as the underlying fundamentals of the asset have not changed. If the recovery persists for an extended period of time, it may be a genuine reversal.
Low volume: A dead cat bounce is often accompanied by low volume, as the recovery is not supported by strong demand. In contrast, a genuine reversal is often accompanied by high volume, as there is strong demand for the asset.
Fibonacci: One accurate way to measure and classify a bounce as a dead cat bounce is to use Fibonacci retracement levels. Whenever the initial signs described above show, this tool can be applied. Generally it is considered a dead cat bounce if the price tops out around the .382 retracement level. A good example of this can be observed below, where the Bitcoin price seemed to recover from a sharp 52% drop over the months that followed, only to find its high at the .382 fibonacci level in early April 2022. Another large drop in price ensued from that point on, and thus can be classed as a dead cat bounce.
Disclaimer: The opinions expressed in this article are for informational purposes only. This article does not constitute an endorsement of any of the products and services discussed or investment, financial, or trading advice. Qualified professionals should be consulted prior to making financial decisions.
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