How to Spot a Dead Cat Bounce

If you are new to options trading or trading in general you may not have heard the expression dead cat bounce. The morbid picture that may come to mind is that even a dead cat will bounce if thrown from a sufficient height. This expression came into being to describe when stock market price spike is not “live” or based in reality but rather dead or without any technical or fundamental support. Learning how to spot a dead cat bounce will keep you out of trouble in the market and even lead to trading profits.

Stock Market Dead Cat Bounce

Historically investors and traders have made lots of money by waiting to buy until the market bottoms out after a correction or crash. In a shorter time scale, buying the dip when the market is headed higher can also be profitable. Unfortunately for unwary traders there are times when an upward market “bounce” is caused by something like a short squeeze and does not represent the beginning of an upward trend or anything but a sign that the market will drop badly.

The Risk of Being Too Hopeful in an Uncertain Market

If your optimism or hopefulness about the market is reflected in broader market sentiment, you will probably make money with a temporary uptick even when long term fundamentals do not support such optimism. This means you need to watch your trade closely and exit with a profit instead of tempting fate when the underlying fundamentals do not support current sentiment.

We saw this in the early days of the Covid pandemic when the S&P 500 was at all time highs and kept going up despite evidence that China was shutting down, the oil market was tanking, and that the virus was beginning to kill people in every corner of the world. Traders who knew no market except that of low interest rates and steadily rising prices in the aftermath of the Financial Crisis had no personal yardstick with which to measure the risk of believing that stocks always go up.

How Do You Recognize a Dead Cat Bounce?

Perhaps the first tip off of a dead cat bounce is that it makes no sense based on fundamental factors or market sentiment.  When a dead cat bounce is caused by something like a significant short squeeze, it can turn into a stock market crash. A dead cat bounce is not an uptick in the trading day that lasts an hour or two. It is a longer-term drop, rebound, and then a continued drop. The term does apply to a stock that is continuing to increase in value. The revival must be brief in terms of days or, occasionally, a week or two, before the price continues to fall.

Understanding Fundamentals and What Drives Market Sentiment

At Top Gun Options we routinely pay attention to events far and wide that have the potential up upset the markets. Our DRINC acronym which stands for Democrats, Russia, Iran, North Korea, and China is an example of how we stay ahead of things in the market and how we strive to understand where the fundamentals will be driving prices over time. On a shorter time frame market sentiment drives prices. In this case traders and investors are seeking to predict where prices are headed and get into positions that will be profitable as time passes. Sometimes market sentiment is right on the money and sometimes it is absolutely wrong. We saw the wrong part when the market kept going up in the face of evidence of how bad Covid was going to be. That is also were we saw repeated dead cat bounces before the market finally turned around and imploded.