How A Dead Cat Bounce Works, Part II

  • March 19, 2003
  • Rob Hanna


After all the questions I got

last week on Dead Cat Bounces, I thought I
would walk through an example, and try and address some of the more common
questions. Last Friday, Consolidated
Graphics
(
CGX |
Quote |
Chart |
News |
PowerRating) came out with an earnings
warning. It then collapsed over 35% intraday before beginning to bounce.


The bounce in this case was
short.  Monday saw the stock move up slightly, but finish at its highs.  On
Tuesday, CGX gapped up slightly, then reversed and finished at its lows for the
day. A candlestick with a small real body similar to Tuesday’s is referred to as
a “spinning top.” It represents indecision between bulls and bears. In this
case, it was a possible indication that the bounce was losing steam. A spinning
top is not one of the strongest candlestick patterns, but when combined with the
fact that CGX closed at its lows for the day, it was a decent indication that
the bounce might be ending.

You may use any reversal pattern you are comfortable with to short a Dead Cat
Bounce. Dave Landry’s pullback techniques are excellent for this purpose. I also
like to look at candlestick patterns.

The trigger to enter the position short came this morning when the stock opened
below yesterday’s low. (If the gap was large, that would have invalidated the
trade, but since it was only 5 cents, the trade should be taken.)  The initial
stop on this trade would have been just above the high of the pullback
(yesterday’s high), or about 25 cents away.


Using 2 for 1 money management
as described in the “TradingMarkets.com
Guide To Conquering The Markets,” half of the trade would be taken off
around $15.15.  This could have been accomplished before 10 am.  The stop on the
second half of the position can then be moved to around breakeven.

I always look at stocks in
multiple time frames. In looking at a weekly chart, you can see that there is
potential support between $14-$14.50. I would therefore look to take profits
on another ¼ of the position if the price gets down around this area and stalls
or reverses back up. For the last ¼, a looser, intermediate-term trailing stop
would be appropriate. If the price actually falls below $14, it could easily
drop another 20%. 


This home-run potential,
combined with minimal initial risk (25 cents) creates an outstanding risk/reward
ratio.  Anytime you can risk 25 cents with the potential of making several
dollars, all while having high probability technical patterns on your side,
you’ve positioned yourself smartly.

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

Now that I’ve gone
through all that, I should say that the path of least resistance for the market
appears to be up right now.  I would concentrate more on the long side, but keep
in mind that we are also due for a pullback. If the pullback isn’t too severe,
and comes on lower volume, that would be an excellent sign for intermediate-term
traders. With the volatile, news-driven environment we are in, it is still a
good idea to be hedged. Therefore, I wouldn’t completely lose focus on the short
side.  Keep your eyes out for opportunities with high risk/reward ratios like
the CGX trade discussed above.

Good luck with your trading.  Feel free to write me with any questions or
comments.

Rob Hanna



robhanna@rcn.com