Dead Cat Bounce Meaning Stock Patterns How It Work

Dead Cat Bounce Meaning

Technical indicatorsTechnical IndicatorsTechnical indicators refer to technical analysis tools used by investors to make investment decisions based on future price movements derived primarily from historical prices. read more, experience, and time play a crucial role in determining whether a declining stock’s sudden upward movement is an actual recovery or instance of DCB.

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Key Takeaways

A dead cat bounce is when the stock prices rise temporarily, following a steady decline that continues for weeks, showing a pseudo reversal or upward movement in the market. After a while, the price hits a new low, continuing the downtrend.Many investors often mistake DCB for an actual recovery leading to financial losses. One can confirm an instance of DCB only after it has taken place.Technical indicators, experience, and time play a crucial role in determining whether a declining stock’s sudden upward movement is an actual recovery or instance of DCB.Usually, if a stock price lowers to at least 5% of the opening price, it could indicate the DCB. Even in the case of volatile stocks, the decline usually needs to be over 5%.The causes of DCB can be the dominance of the bears, clearing out short positions, and a sudden increase in the buying pressure.

How Does Dead Cat Bounce in Stock Markets Work?

The price pattern indicated on an index reflects the current status of the market. The ups and downs in the chart keep investors and money managers up to date. It also helps them make crucial financial decisions ahead. A bearishBearishBearish market refers to an opinion where the stock market is likely to go down or correct shortly. It is predicted in consideration of events that are happening or are bound to happen which would drag down the prices of the stocks in the market.read more market is more prone to DCBs. Individual stock, overall market, options, etc., can be a victim of DCB.

Let us understand the concept of dead cat bounce with a simple example.

The stock of a clothing brand, CLO, had been doing phenomenal, earning a peak in its price at $1000 per share. However, following the news of a series of scams at CLO, its stock price fell abruptly to $300. Despite the management’s efforts, CLO’s stock price fell, leading to a downtrend.Investors began to sell their short positions to reap profits. Short positionsShort PositionsA short position is a practice where the investors sell stocks that they don’t own at the time of selling; the investors do so by borrowing the shares from some other investors to promise that the former will return the stocks to the latter on a later date.read more help bearish traders gain from a loss-making stock. Long positionLong PositionLong position denotes buying of a stock, currency or commodity in the hope that the future price will get higher from the present price. The security can be bought in the cash market or in the derivative market. The course of action suggests that the investor or the trader is expecting an upward movement of the stock from is prevailing levels.read more investors who benefit from a profit-making asset also pitched in.Long position investors thought the price had reached its extreme low and bought shares hoping that the price would grow. This movement around CLO’s stock pushed up its price to $400.This rally in the price appeared to be a reverse trend to some investors. However, those exercising caution remained wary as they were apprehensive of being a DCB. After a short-lived recovery, CLO’s stock price fell significantly, hitting its lowest in 30 years at $100.This indicated that the downtrend had continued, and the brief price recovery was an instance of dead cat bounce. Much like the phrase that even a dead cat bounces, a declining asset might experience a sudden price burst.There were instances of a slight recovery in CLO’s stock; however, the price continued to fall due to resistance. After two years, the stock eventually recovered, hitting $400, and went into an uptrend.

It isn’t easy to differentiate between a DCB and actual recovery. DCBs can only be realized when they have occurred, but trading experts and analysts stay on the lookout. Technical tools, overall market performance, important news from the financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more, experience, and time, are some ways to help understand the movement of DCB. For example, experts are cautious of market volatility in the aftermath of the Covid-19 that has left many economies in shambles. Conversely, an underperforming market loaded with economic debacles is more likely to incur a DCB.

Also, for the price of any tradable asset to be considered for a dead cat bounce pattern, if a stock price lowers down to at least 5% of the opening price, it could be an indicator of the DCB. Even in the case of volatile stocks, the decline usually needs to be over 5%.

Examples

Let us go through some more examples of dead cat bounce to clarify the concept.

Multiple amateur investors were looking to start with small investments in the trading market. Hence, they bought the short positions sold by the bears. This sudden increase in the buying pressure led to the temporary upward movement in the value of tradable assets following a continuous decline for weeks.Some investors often refer to DCB with varied expressions such as false hope, fake rally, etc. Many reports have talked about the series of false hopes happening before and during the Great Depression. As per a Fortune piece, there was a 47% rally between late-1929 till early 1930. Before the 47% short-lived recovery, the stocks had fallen 45%. However, the false hope lasted only a bit before the stocks fell by more than 80%. There were false hopes, and the dot-com bubble burst even during the bear markets of 1973-1974 and 2000-2002. Investors worldwide suffered greatly due to such crashes, with many firms going out of business.

Causes of Dead Cat Bounce

After the steady lowering pattern, the short-term rise in the stock value could result from several factors. Here are a few points that could lead to a DCB:

#1 – Negative Dominance

When bulls dominate the stock market, they make it economically sound. However, when the bears become dominant, the stock value downtrend leads to a steady decline. The bears are the pessimist investors who are suspicious of the market. They assume that the values will degrade in the coming times, and hence, they tend to change their purchase behavior. It leads to a rise in the value, forming a dead cat bounce pattern.

#2 – Clearing Out

The fluctuation observed in the trade market is quite a common phenomenon. But when a stock keeps declining continuously, leading to a steep low slope in the chart, certain investors become active. These investors are bear, short-term, short-sellers, and even some value investors. With the short position buyers increasing in number after a steady downtrend, a sudden rise in the stock prices is observed, leading to a DCB.

#3 – Buying Pressure

The momentum investors begin creating long positions post-analysis of the oversold readings. It enhances the purchase of the long stocks, thereby increasing the buying pressure leading to DCB. After a period of decline, the sudden increase in sales figures is reflected in a rise in the stock value.