Here’s What To Look For In A Dead Cat Bounce
The market continued to rally today for the fourth day in a row. Volume has picked
up slightly the l ast two days but is still below average levels. Also of note
is the fact that the S&P’s 50-day SMA crossed below the 200-day SMA
today for the first time since May 2003. At this point, I’m still seeing
very little to convince me that this will turn out to be anything more than a
dead cat bounce. I believe the market is still headed lower. In addition to the
fact that the S&P and Dow are at/near resistance levels the market is also
getting very near to short-term overbought levels. I expect this situation will
begin to resolve itself with a move lower sometime in the next few days. When
I believe the market is in dead cat bounce mode I like to look for potential candidates
to short that are also experiencing dead cat bounces.
In March of 2003 I wrote about playing Dead Cat Bounces. Most of what follows
is from that article…
A classic Dead Cat Bounce is when a stock sells of very sharply, usually based
on some bad news, then rebounds from the sell off, only to roll over again.
It is a very reliable pattern that, if played correctly, can offer tremendous
risk/reward.
^next^
The psychology behind it is simple. When a stock drops very sharply in a short
period of time, bargain hunters will always arrive. These bargain hunters will
halt the downfall, and begin to drive the price back up. Many times though,
since the stock sold off so sharply to begin with, some of the largest holders
may not have had a chance to unwind their positions. They begin selling into
the bounce causing downward pressure on the stock once again. The bargain hunters
who just bought get scared and they start selling. All of a sudden the stock
is once again headed for new lows. Lastly, bad news is rarely followed by a
lot of good news. If something is really wrong with the company, you’ll
likely continue to get more bad news over the coming weeks and months. This
will just add more downside pressure.
It is very easy to find potential candidates for playing dead cat bounces.
All you need to do is check to see which stocks got hit the hardest each day,
and keep a list of them. I normally like to look for stocks that have dropped
at LEAST 15% or 20% in one day — on HUGE volume. If the stock gaps lower
to start the sell-off, even better.
I then wait for the bounce, and short once I get a signal that the downtrend
is continuing. The reason I like to wait for the bounce, rather than just sell
short during the initial mayhem, is it provides me a place to set my stop and
control my risk/reward.
Here are a few examples of dead cat bounces:
You can begin building a list of Dead Cat candidates simply by tracking those
stocks that drop the most each day.
Another excellent place to look for stocks that may be exhibiting this pattern
is on the Tradingmarkets.com indicators page. Both the “Proprietary Implosionâ€
list, and the “Pullback From Lows†list may provide solid candidates.
To sum up, the main things I look for when trading a Dead Cat Bounce are:
1) Huge initial drop on big volume
2) Weak bounce
3) Reversal trigger to go short
4) High risk/reward ratio
In my opinion, hunting for dead cats is one of the easiest and safest ways to
hunt…and sell short.
Best of luck with your trading.
Rob
robhanna@comcast.net