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Extremely volatile markets create an environment for the formation of a very specific type of technical price pattern. The "Dead Cat Bounce" pattern (DCB) may have a macabre name but it comes with very nice profit potential and is relatively easy to identify.
At its heart, the DCB is a great study in investor psychology. It occurs when investors have panicked or have been caught by surprise which is why the pattern occurs most frequently in bearish and volatile markets. Investor psychology comes into play because traders are likely to become fearful at the same price levels that they have been fearful before. We use the DCB to identify those price levels for potential breakouts.
The pattern consists of a gap during a downtrend when prices move down between the close one day and the open of the next trading day. The larger the gap is the more significance technicians will assign to the pattern. The gap is typically created by unexpected news appearing after or before normal market hours. Traders will move prices very fast and an "overreaction" may occur.
The market becomes oversold at some point and will begin to rally back towards the gap. The top and bottom of the gap will act as resistance barriers and if the market or stock peels off of these resistance levels, the subsequent decline can be quite significant. The rally back towards the gap is a good example of a bull trap and the final decline that completes the pattern can be very fast as a feedback loop of stop losses pushes more sellers into the market.
Figure 1: Goldman Sachs Daily Chart
In the chart above you can see a DCB beginning to form on Goldman Sachs (GS | Quote | Chart | News | PowerRating). Once a breakout to the downside occurs, shorts enter the market. Buying puts at this point is a great way to limit your risk while still taking advantage of the downside potential.
In the next section of this article I will show you how you can project price targets once the pattern has completed itself.
John Jagerson is the author of many investing books and is a co-founder of LearningMarkets.com and ProfitingWithForex.com. His articles are regularly featured on online investing publications across the web.
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