A saying goes: “Even dead cats bounce if they fall from a great height.” Before, when there is a minimal comeback in the course of a significant decline, people on Wall Street would use the phrase “dead cat bounce.”
What is dead cat bounce?
Whenever there is a minimal price recovery in a declining asset, we refer to this scenario as dead cat bounce. If we are talking about technical analysis, we refer to the dead cat bounce as a price continuation pattern.
The confusion between the dead cat bounce and trend reversal
Some traders might think that a dead cat bounce is a trend reversal. The beginning stages of the dead cat bounce are somewhat similar. As it begins with a downward movement, a significant price retracement will succeed; that is why some traders mistake it for a trend reversal. But in the longer run, the price does continue to rise. The trend continues to decline that breaks the previous support level and develops new lows.
In some instances, traders make the mistake of going long with hopes of trend reversal only to find out that the reverse will never happen. In this scenario, the dead cat bounce became a bull trap that victimized traders.
Explaining dead cat bounce further
Let us explain what happens in a dead cat bounce in detail. In situations where an ongoing bear market or decline has been happening for a long time, there are circumstances that prices may have a short-term or temporary recovery or increase. Later on, this increase will not continue, but the downtrend will. These quick recoveries are not uncommon in downtrends. A trader who made moves because of the sudden increase will only realize the wrong trading decision only after all is said and done. Dead cat bounce situations are very tricky and challenging to identify.
Why are there short-lived increases?
What can cause a downtrend interruption? Some traders close their short positions, and some buy because they think that the asset will not rise anymore due to the prolonged downtrend.
Dead cat bounces are challenging to detect if not unidentifiable. Some people like the analyst may try to know if the price recovery will last by using technical and fundamental analysis tools, but there is no guarantee. Traders can only recognize a dead cat bounce in hindsight.
Traders may get clues whether the price recovery is temporary or not on the situation of the economy. Is there a recession? There are also clues that we can see on the prices of individual stocks and stock groups.
So, should we still trade when there is a possibility of a dead cat bounce?
There is no limit on trading, and every trade poses risks. It is a trader’s responsibility to know the situation of the economy, the market, individual stocks, and stock groups. A trader can also research analysts’ opinions if there are doubts that a price recovery during a bear market will only be temporary. But at the end of the day, it all depends on a trader’s skill and speculation. Some traders may still try to make a profit regardless if it is a temporary or continuous price increase by using a short position.