This Is How A Dead Cat Bounce Works
The
markets made quite a turnaround today, as the S&P 500
and Dow rallied nearly 2% from their lows to finish up about 0.4%. The Nasdaq,
after finally taking out last month’s lows, finished even better. Fear has been
growing slowly and we finally saw the VIX spike above 40 today. Overall, it was
a nice turnaround, and a nice finish. Let’s not all start slapping each other on
the market bottoms just yet, though. I’m going to need to see a lot more
evidence to convince me any bounce or rally is for real — evidence in the form
of accumulation days, breadth, leadership, and confirmation of foreign markets
(most of which are very ugly right now).
Until that happens, I’m assuming this
is going to turn into another dead cat bounce. And if it is, my favorite way to
play it is to look for potential candidates to short that are also experiencing
dead cat bounces.
A classic dead cat bounce is when a stock sells off 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.
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.Â
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.
Here are a few examples of recent dead cat bounces:
If you want to start building a
list of your own, the following stocks had huge sell-offs on Monday and Tuesday
of this week (you’ll have to do your own work for today’s list):
(
GTSI |
Quote |
Chart |
News |
PowerRating),
(
PRAA |
Quote |
Chart |
News |
PowerRating),
(
UNM |
Quote |
Chart |
News |
PowerRating),
(
CE |
Quote |
Chart |
News |
PowerRating),
(
INSP |
Quote |
Chart |
News |
PowerRating),
(
KG |
Quote |
Chart |
News |
PowerRating),
(
DAL |
Quote |
Chart |
News |
PowerRating),
(
FIF |
Quote |
Chart |
News |
PowerRating),
(
MYG |
Quote |
Chart |
News |
PowerRating),
(
CAL |
Quote |
Chart |
News |
PowerRating).
Another excellent place to look for
stocks that may be exhibiting this pattern is on the Tradingmarkets.com
indicators page. Both the “Proprietary
Implosion†list, and the “Pullback
From Lows†list may provide solid candidates.
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. Feel free to write me with any questions or
comments.
Rob Hanna
P.S. For more information you may want to check out Gary Kaltbaum’s lesson, “My
Favorite Strategies For Gaps Up And Gaps Downâ€
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