A stock just gapped down by more than 5% on the open, relative to the prior closing price, and it is continuing to fall. Soon the stock is down by 8%, but then it starts to rally. Some investors who were thinking about buying the stock yesterday jump in, thinking the stock is a bargain at a 5% to 8% discount.
Day traders who went short early in the morning cover their short positions, helping to fuel the bounce. Soon, the price is back near where it opened, but still down 5% on the day. That's when the price plummets lower once again, as those who hadn't sold their shares that morning are relieved to do so near the opening price.
This is called a "dead cat bounce." Here's how to make money on it.
- A dead cat bounce is a sharp decline in a stock's price, followed by a failed rally and further decline.
- The dead-cat-bounce trader watches the price fall; when it starts to bounce, they get ready to go short.
- A bounce is a second chance for scared investors to unload shares, which will push the stock price lower and create an opportunity for short-selling day traders.
What Is a Dead Cat Bounce?
In the simplest terms, a dead cat bounce is a sharp decline, followed by a failed rally and further decline. Like with all charting patterns, the exact parameters of a dead cat bounce are somewhat up for interpretation. However, there are four general features to look for as you learn how to best define a dead cat bounce for yourself.
For a dead cat bounce to occur, a stock must gap lower (i.e., dip at the open) by a significant percentage. As a general rule of thumb, 5% might be a good number to look for, but it depends on how the stock performs on a typical day. If a stock is always volatile, then a 5% gap down might not be all that unusual. For stable stocks that hardly move much on a day-to-day basis, then a 5% gap down—perhaps even a 3% gap down—would deserve attention.
The price must continue to decline for at least five minutes after the opening bell—preferably longer. As with the gap percentage, five minutes is just a guide. The point is that the price needs to continue falling after the open. If it doesn't keep falling after the gap down, then it isn't a dead cat bounce, and you shouldn't try dead-cat-bounce trading strategies on it.
The Dead Cat Bounce
After the sustained decline, the namesake bounce starts to occur. A stock should get close to the initial gap-down opening price. For example, if it opens down by 5% at $9.20, and then declines to $9, a dead-cat-bounce trader will watch for the price to get close to $9.20 again. The price might not hit the opening price perfectly, so traders must remain flexible and study the price movement carefully.
After the dead cat bounce, the price plummets again. At that point, the dead cat bounce has completed its pattern, and traders will watch for the best exit points.
Shorting a Dead Cat Bounce
The gap-downs that start a dead cat bounce are usually due to fundamental news that came out overnight, such as an earnings release. The dead-cat-bounce trader watches the price fall, and when it starts to bounce, they get ready to go short.
Why short? Because "the cat is still dead." Just because the stock bounced doesn't mean it's going to keep surging. Significant damage was done to the stock price, the underlying issues with the company are still there, and investors are still scared. A bounce is a second chance for those scared investors to unload shares, which will push the stock price lower and create an opportunity for short-selling day traders.
Watch for the price to rally back into the vicinity of the opening price. Remember, the area around the opening price is likely to be a resistance level, but that is just a guide. You want the price to come close to the opening price, but it might stay below or go just above. Once the price enters the vicinity of the opening price, be on high alert for taking a short position.
Take a short position only once the price starts to drop again. By waiting for the price to start dropping after nearing the opening price, the day trader has more confirmation that it actually is a dead cat bounce.
You can use a stock screener to see the stocks that have gapped down in the morning. Every stock screener should have some filter that helps you find the top losers of the day. Remember to set this to a percentage rather than a dollar amount—a $40 drop might be an insignificant dip for one stock and a huge gap-down for another.
Stop-Losses and Price Targets
Dead cats that bounce may eventually return to where they bounced from. While no strategy works all the time, if the price respects the open and declines off of it, it will often retest the low price created before the bounce (the morning low). Therefore, the initial price target for the short position should be just above the prior low. Ideally, you would exit part of the position there.
If the price starts to rally again, exit the rest of the position. If it breaks below the low of the day, hold on to the remainder of the position, and exit at the first sign of a bounce. A tight trailing stop works well in this situation.
When the short position is taken, place a stop-loss order just above the recent high that occurred just before you went short. Remember, we are waiting for the price to turn lower, which means there must be a high point above our entry price before we enter. This stop-loss is a guide, so making slight adjustments is acceptable.
The stop should be out of reach of normal fluctuations while still keeping risk-controlled and allowing the profit potential of the trade to outweigh the risk.
Shoot for trades that offer at least a 2:1 reward/risk ratio. If the stop-loss is $0.50 above your entry price, for instance, then the first target should be $1 or more below the entry price.
The Bottom Line
The key level in a dead-cat-bounce trade is near the opening price of the original gap-down day. Often, the price will retest this level the same day, offering day traders a chance to get short soon after spotting the gap-down.
The gap-down level will often remain significant for days and weeks into the future, as well. It may serve as the resistance level for several days until there is a breakthrough, at which point it could become a support level. Therefore, even if you aren't a day trader, it's worthwhile to pay attention to any dead cat bounces to see whether they provide swing trading opportunities.