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How to Trade the Dead Cat Bounce

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Background

The Dead Cat Bounce is a bearish structure that occurs mainly due to a high impact event, for example, news related, significative report or a speech of a central bank. In this article, we will talk about how to recognise this pattern, its characteristics and how to trade it.

The Dead Cat Bounce is a small and temporary market recovery following a large fall. The first quotation was made in an article by Chris Sherwell in The Financial Times, 7th December 1985, where they wrote:

“The rise was partly technical and cautioned against concluding that the recent falls in the market were at an end. ‘This is what we call a dead-cat bounce,’ one broker said flatly.”

However, the race for the phrase authorship does not end here, recently in a Letter to the Editor in The Financial Times, 19th July 2017, Jude Kinne wrote:

“I was the ‘trader in Singapore’ to whom the Financial Times’ Chris Sherwell attributed the “dead cat bounce” quote”.

Even in the literature classic by Mark Twain “The Adventures of Tom Sawyer”, written in 1876, in chapter 6 it appears quoted the “dead cat” in a dialogue between Tom and his friend Huck:

“Say – what is dead cats good for, Huck?”

“Good for? Cure warts with.”

“No! Is that so? I know something that’s better.

Now that we know a little of its history, the question is, what are the characteristics of the Dead Cat Bounce Pattern? The main component is that the movement begins with a decline of more than 10%, breaking down the previous low, ideally leaving a price gap. Please note that on continuous markets, for example, Forex or Cryptocurrencies markets, there may not exist a gap. If the prices break down more than 20%, it is indicative of the seriousness of the plunge.

When panic is caused a news event appears. ‘Recovery’ begins, as prices start recovering and moving upward. Do not be attracted to enter on this recovery, thinking about an uptrend continuation on the left side of the screen, because the decline is still not over. After the bounce ends, another downward movement begins. This drop could still be between 5% to 25%.

Once we have detected a potential “Dead Cat Bounce” pattern, the recovery could reach the 50% to 61.8% of Fibonacci retracement (see our articles Understanding the Fibonacci Sequence and Making a Trading Plan Using Fibonacci Tools).

  • Entry: Enter in a short position when the price reaches the 50% to 61.8% Fibonacci retracement level of the first fall.
  • Stop Loss: Place a Stop Loss Order above the 76.4% Fibonacci retracement level of the first fall.
  • Profit Target: The target must be the 76.4% with extension in 100% of the Fibonacci projection (see our article Trade the Harmonic AB=CD Pattern).

Now that we know the requirements to understand the Dead Cat Bounce Pattern, let’s put all together with an example. Figure 1 is the 4-hour FTSE 100 chart, on the 8th of August  2017, the FTSE makes a plunge, leaving a bearish gap, and the downfall extends to 7290.07 on August, 11.

Figure 1: FTSE 100, 4-hour chart, Potential Dead Cat Bounce Pattern.

Source: Personal Collection.

In the August 14 session (see figure 2), its recovery begins, reaching the 7446.57 pts. The recovery movement ends between the 50% to 61.8% of Fibonacci retracement; this area is our entry level. The Stop Loss order is placed above of 76.4% level.

 

Figure 2: FTSE 100, 4-hour chart, Entry Zone and Stop Loss Identification.

Source: Personal Collection.

Once that we have the entry and stop loss levels, using the Fibonacci expansion tool, we project the target profit level (see figure 3).

Figure 3: FTSE 100, 4-hour chart, Profit Target Identification.

Source: Personal Collection.

Another example is in figure 4, Bitcoin daily chart, this is a possible scenario in development. The movement begins with a sharp fall from $19,898.12 to $10,694.22 level from where the recovery started, reaching the 61.8% Fibonacci retracement; from this level, the Bitcoin continued the downward movement. As the Bitcoin is still developing the pattern, this example will be used as a followup on its evolution.

Figure 4: Potential Dead Cat Bounce Pattern in Bitcoin, daily chart.

Source: Personal Collection using JAFX MT4 Plattform.

 

A final consideration to increase the learning process of the reader is to perform a backtest to evaluate the correct setups works adjust better to their trading style.

 

SUGGESTED READINGS:

  • Kinne, J. (July 8, 2017). I was that trader – but I’d heard the phrase before. Financial Times: https://www.ft.com/content/af4fc1b0-6b12-11e7-bfeb-33fe0c5b7eaa (Recovered on December 30, 2017).
  • Twain, M (1884). The Adventures of Tom Sawyer. Chapter 6. https://www.gutenberg.org/files/74/74-h/74-h.htm#c6 (Recovered on December 30, 2017).

 

 

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