The Dead Cat Bounce Back Strategy

A stock just gapped down more than 5% on the open, relative to the prior closing price, and is continuing to fall. Soon the stock is down 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. The price then 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 a dead cat bounce. Here's how to make money on it.

The Dead Cat Bounce Explained

For a dead cat bounce to occur, a stock must gap lower by a significant percentage. As a general rule of thumb, 5% might be a good number to look for. If a stock is always volatile, the gap should be bigger than 5%. If it isn't a volatile stock, then a 5% gap down deserves 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 the price doesn't keep falling after the gap down (the dip at the open), then we can't have a dead cat bounce and, therefore, this strategy doesn't apply.

Such drops 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 are still there, and investors are scared. A bounce is a second chance for those scared investors to unload shares, pushing it lower. Day traders should watch for this.

When to Go Short

A dead cat bounce is when the price gaps down 5% or more, continues to decline after the open, but then has a rally.

Watch for the price to rally back into the vicinity of the open price. The area around the open price is likely to be a resistance level. This is, once again, a guide. You want the price to come within a couple of percentage points of the open price—it may stay below or go just above. Once the price enters the vicinity of the open 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 open price, the day trader has more confirmation it actually is a dead cat bounce.

Using the Finviz stock screener, choose Signal: Top Losers, to see the stocks which have gapped down in the morning. Upgrade to Elite Finviz for real-time quotes and pre-market data. Set Average Volume to at least 500,000 or 1 million to assure all the stocks generated on the list have adequate volume for day trading.

Stop Losses and Price Targets

Dead cats that bounce 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 is 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. Or, if the price breaks below the low of the day, hold onto 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 several cents above the recent high which 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 from your entry price, then the first target should be $1 or more below the entry price, based on the guidelines above.

The Bottom Line

The key level in a dead cat bounce trade is near the open 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. This level is often significant days and weeks into the future as well. You may go short today, and the price falls, but a week down the road it may come back to test the same level—a second dead cat bounce. As many as three dead cat bounce trades can result from a single gap down. Three dead cat bounce trades is the maximum for one gap, though. Beyond that, it is best to look for other opportunities.