A dead cat bounce occurs in two stages. The first stage is when the price of an asset makes a temporary recovery after a prolonged decline. This is followed by the continuation of the original downtrend that takes the price past the original low.
Dead cat bounces typically occur during bear markets and can be found in any asset, although they are most widely reported in stocks and stock indexes.
The unfortunate term “dead cat bounce” was coined because of the notion that even a dead cat would bounce if it falls from a height.
The example above is often used to illustrate the dead cat bounce. The dot come bubble was at its height coming into the new millennium. Cisco was no exception with its stock price peaking at $82 in March 2000.
Over the proceeding 13 months the share price of Cisco fell 84% to a low of $13 by April 2001. Many traders thought this must have been the bottom as they bought Cisco over the coming month. By May 2001 the price had increased 84% to $24.
They were premature though. Cisco then continued its downward spiral by falling 54% to a new low of $11 by September 2001. Traders again thought this must be the bottom, especially after the tragic events of that same month. By Christmas 2001 the price had again rallied by 100% to reach $22.
You can probably guess what happens next. They were again premature and the price of Cisco fell by another 64% to a new low of just $8 by Christmas 2002.
From peak to trough the price of Cisco fell by 90%. This stock fell so far and so fast that it bounced twice.
What to learn from the dead cat bounce phenomenon?
A dead cat bounce is a short lived recovery after a prolonged decline in price. The price then continues downwards to set new lows. For this reason the phenomenon is considered a continuation pattern.
This type of continuation pattern is usually only spotted after it has occurred. Although after a steep decline a seasoned trader should always be aware that the fall may be accompanied by an unfortunate feline.
Are dead cat bounces part of technical analysis?
They are made up of pure price action and can be spotted on charts for most asset types. They most commonly reported for stocks and shares and indexes.
You can also find dead cat bounces on other timeframes, although they have more significance on daily and weekly charts.
What to avoid?
The unfortunate trader will interpret the brief recovery in price as the pain ending. They may even delve into the market with a lax approach to risk management. The example above shows that this would be a second, or third, very painful mistake. Always use sound risk management and responsible position sizing.
Be ready for a dead cat bounce but never try to predict one. A small recovery in price can easily turn into a significant rally, or even a raging bull market. Markets quite often recover in a “V” shape with the recovery as swift as the decline. No dead cats can be found anywhere in these scenarios.