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After a steep drop in price, stocks and other securities will usually have what is called a “dead cat bounce.” It’s called that because of an old saying that says if a dead cat falls far enough, it will bounce.
The movement is a short-term jump in price that usually doesn’t last.
Reversal of Downtrend or Dead Cat Bounce?
A dead cat bounce will trap many inexperienced bulls who are eager to get in after a significant fall.
Investors will often catch a falling knife trying to time the bottom instead of waiting for the downtrend to reverse.
A big enough drop can also break a previous uptrend. So, the bounce could only be a small rally before the continuation of a new downtrend.
You can tell if it’s a dead cat bounce a few different ways–mostly by using basic technical analysis.
- The price will need to go above an area of resistance that breaks out of the downtrend.
- You will want to see it hold above its previous downtrend resistance and treat it as support.
- Look for news or a positive fundamental change on heavy trading volume.
Example of a Reversal
In this chart using the 1-day timeframe, we can see the price break through the downward trend.
It later treats the previous resistance as support before another large move up. As you can see, it takes time for a reversal to play out and be confirmed.
Example of a Dead Cat Bounce
This 1-day chart shows a typical dead cat bounce. First, the price rebounds substantially but later continues to fall in line with the declining trend.
Buyers who attempted to buy the bottom thought it wouldn’t get any cheaper. They should have been watching the overall long-term trend.
Should You Buy During a Possible Dead Cat Bounce?
If you are trying to determine whether or not you should invest during a bounce, consider these three things.
- Is it nearing its downtrend resistance? If so, it will likely fall again.
- Are there any fundamental changes or upcoming catalysts that can reverse the downtrend?
- Is the reason for the sell-off/bounce valid?
Dead cat bounces often happen in all investments after a dramatic sell-off. The security is oversold and catches a relief rally before dropping more. Bear markets are full of them.
Short-term traders will buy after a big drop and sell on the dead cat bounce. The risk is that a bounce isn’t guaranteed. Long-term investors should pay less attention to this type of action.