After opening lower by more than 5% from the previous day's close, a stock's price has continued to drop. The share price will drop by 8% quickly but then rise again. Traders contemplating buying the stock yesterday now do so because they believe it is a steal at a 5% to 8% discount.

Short positions taken by day traders in the morning are covered, adding fire to the rebound. In little time, the price is back where it started the day, although 5% down. As individuals who hadn't sold their shares earlier in the day are glad to do so around the opening price, the price drops again.

How Does a Dead Cat Bounce Work?

In its simplest form, a dead cat bounce is a steep drop followed by a shaky attempt at a recovery that ultimately fails. The precise dimensions of a dead cat bounce are up to interpretation, as is the case with any charting patterns. Although the precise characteristics that constitute a dead cat bounce are unique to each individual, there are four broad indicators to keep an eye out for.

Gap Down

A stock must gap far lower to have a dead cat rebound. The average daily performance of the stock in question will determine whether or not a 5% return is reasonable to target. A gap of 5% would not be that surprising for a historically volatile stock. In the case of equities that seldom change in price daily, even a 3% gap down would warrant investigation.

Sustained Decline

After the opening bell, the price must stay low for at least five minutes. In the same way that the gap % is only a suggestion, so too is the gap time of five minutes. The key is for the price to keep decreasing when the market opens. Don't apply dead-cat-bounce trading tactics if the price action following the gap down doesn't indicate further downward movement.

Reviving the Dead Cat Bounce

The so-called "named bounce" occurs after a prolonged drop. When a stock opens with a gap down, it should eventually close the gap and return to its opening price. A dead-cat-bounce trader, for instance, would wait for the price to return to the $9.20 area if it opened down 5% at $9.20 and then fell to $9. Traders must be adaptable and watch price action closely because the initial price may not be the final price.

The Dead Cat Bounce: Shorting the Market

In most cases, essential overnight news, like an earnings report, causes the gap-downs that kick off a dead cat bounce. Traders that employ the dead-cat-bounce strategy wait for the price to drop and then short it on any signs of a rebound.

The stock's recovery is no guarantee that it will keep on rising. Even if the stock price has recovered somewhat, investors are still wary since the underlying problems with the firm have not been resolved. If the stock price recovers, it gives investors a second chance to sell out of fear, which benefits short-sellers and day traders.

Price Goals and Loss Limits

Bouncing dead cats may land back where they came from. However, no trading method is guaranteed to succeed if the price drops off the open and holds that support; it will typically return to that level after a bounce.

As a result, a prudent short-term price objective is somewhere around the current level, plus the amount that the price has moved since the last low. This is a good spot to get out of the situation.

You should close the balance of your trade if the price starts to rise again. If it drops below the day's low, you should ride out the decline and get out of the trade as soon as possible after a price recovery. If you're in this predicament, a short trailing stop is your friend.

Set a stop-loss order at or above the most recent high before entering a short trade. Remember that our goal is to get in when the price turns down. Therefore there must first be a high point above our target price. If necessary, you can make small tweaks to this stop-loss.

The Conclusion

Important support and resistance in a dead-cat-bounce trade might be found close to the starting price of the original gap-down day. Day traders might take advantage of the gap-down by getting short as soon as the price retests the support level on the same day.

The gap-down level may often continue to be strong for days or even weeks after the initial drop. It might act as opposition for a few days until a breakthrough occurs, at which time it could act as support.