Dead Cat Bounce: Definition, Causes, and How Traders Use It

What Is a Dead Cat Bounce?

A dead cat bounce occurs when an asset that has been in a strong downtrend experiences a brief price recovery before continuing its decline. The term comes from the idea that even a dead cat will bounce if it falls from a great height—but that doesn’t mean it’s alive.

Key Characteristics of a Dead Cat Bounce

• A sharp price decline occurs.

• The price temporarily rebounds, often looking like a recovery.

• The recovery fails, and the price resumes its downward trend.

• It can mislead traders into thinking the market has bottomed out.

Understanding this pattern is crucial because buying too early in a dead cat bounce can result in losses if the price continues to drop.

Causes of a Dead Cat Bounce

Several factors contribute to a dead cat bounce:

1. Short Covering: Traders who previously shorted the asset (betting on a price drop) close their positions, causing a temporary increase in demand.

2. Market Overreaction: After a steep decline, some traders assume the asset is oversold and buy in, causing a brief price increase.

3. False Optimism: Positive news or technical indicators may create the illusion that the trend is reversing.

4. Low Liquidity & Volatility: Sudden price jumps can happen when there aren’t many buyers and sellers in the market.

Types of Dead Cat Bounce: Regular vs. Inverted

Regular Dead Cat Bounce

This is the most commonly known form of a dead cat bounce and occurs in bearish markets.

Characteristics

• Price drops significantly due to selling pressure.

• A short-term price recovery occurs, making it appear as if the downtrend has ended.

• The asset fails to sustain the recovery and resumes its decline.

• Often leads to short-selling opportunities for traders.

Dead Cat Bounce Example

A stock falls from $100 to $60, then briefly rises to $70 before dropping further to $50. That short-lived recovery from $60 to $70 is a classic dead cat bounce.

Trading Strategy

• Short-sellers wait for the bounce and enter positions once the upward momentum weakens.

• Volume and resistance levels help confirm that the bounce is temporary.

• Stop-loss orders are placed above key resistance levels to minimize risks.

Inverted Dead Cat Bounce (Bull Trap)

The Inverted Dead Cat Bounce is the opposite of the regular pattern. It occurs in bullish markets when an asset experiences a sudden, temporary drop before continuing its upward trend.

Characteristics

• The asset is in an uptrend but experiences a sharp decline.

• The decline tricks bearish traders into thinking the trend is reversing.

• After the brief drop, the price recovers quickly and continues upward.

• Often leads to losses for short-sellers who mistake it for a reversal.

Inverted Dead Cat Bounce Example

A stock rises from $50 to $100, then suddenly drops to $85 before bouncing back to $120. The drop from $100 to $85 looked like the start of a downtrend, but it was actually an inverted dead cat bounce, trapping short-sellers.

Trading Strategy

• Long traders can use the drop as a buying opportunity if there are signs of a continued uptrend.

• Bearish traders should confirm a true downtrend before short-selling.

• Technical indicators like RSI, MACD, and support levels help determine if the dip is temporary.

Identifying Dead Cat Bounce Patterns

Traders use different techniques to recognize a dead cat bounce and avoid getting trapped.

Key Indicators to Watch:

• Volume Trends: A true recovery is supported by strong buying volume. A dead cat bounce often has weak volume.

• Resistance Levels: If the price struggles to break through key resistance levels, it might be a false rebound.

• Moving Averages: If the price stays below major moving averages (e.g., 50-day or 200-day), the downtrend is still intact.

• RSI (Relative Strength Index) & MACD: If momentum indicators show weak buying pressure, the bounce may not be sustainable.

Dead Cat Bounce Example:

Let’s say a stock drops from $100 to $60 due to poor earnings. After hitting $60, the price briefly recovers to $70. Some traders might believe the stock is recovering, but soon after, it falls to $50, continuing the downtrend. This short-lived recovery from $60 to $70 is a dead cat bounce example.

How Traders Use a Dead Cat Bounce Trading Strategy

Traders who recognize a dead cat bounce can use it to their advantage, particularly in bearish markets.

Short-Selling Opportunities

• Traders wait for the bounce and enter short positions when they see signs that the recovery is losing momentum.

• Stop-loss orders can be placed above resistance levels to manage risk.

Avoiding Traps

• Traders avoid buying too early without confirmation of a real reversal.

• They use multiple indicators to confirm whether the trend is actually changing.

A well-planned dead cat bounce trading strategy helps traders avoid false signals and capitalize on the continuation of the downtrend.

Dead Cat Bounce vs. Trend Reversals

It’s important to distinguish between a dead cat bounce and a true market reversal.

Dead Cat Bounce Trading Strategy

Here’s a setup that helps traders spot selling opportunities and avoid being trapped by false reversals.

1. Strong Bearish Trend

   • The asset is experiencing a significant downtrend, indicated by consecutive red candlesticks.

   • This suggests heavy selling pressure and a weak market.

2. Bearish Trend Line

   • A trendline is drawn to track the downward impulse, showing the overall bearish momentum.

   • This helps traders identify if the bounce is temporary or a true reversal.

3. Temporary Price Increase

   • The price recovers briefly, creating a false bullish signal that might mislead traders into thinking the downtrend is over.

   • This is the dead cat bounce phase where some traders buy, assuming a reversal.

4. Marking the Last Bottom

   • Traders set a support level based on the most recent low.

   • If the price fails to stay above this level, it confirms the continuation of the downtrend.

5. Pattern Confirmation

   • Once the price drops below the previous bottom, the dead cat bounce is confirmed.

   • This signals that the earlier rebound was a trap and that the market is continuing downward.

6. Sell Signal

   • Traders enter short positions at this stage, expecting further price decline.

   • This aligns with the overall bearish trend, making it a strategic entry point.

7. Stop-Loss Placement

   • A stop-loss is placed above the recent high formed during the temporary bounce.

   • This protects traders in case the price unexpectedly reverses.

Conclusion

A dead cat bounce is a deceptive pattern that can mislead traders into believing an asset’s price is recovering when it’s actually just a temporary rebound before another drop. Recognizing this pattern is crucial to avoid losses and even capitalize on short-selling opportunities.