”Even a dead cat will bounce if it falls from a great height” – I’ve learned this phrase from the Wikipedia’s article about the Dead cat bounce pattern.
This famous Wall Street saying refers to a situation when a subject experiences a brief recovery during or following a sharp drop. I would like to emphasize the word “brief” here because, in general, such recoveries indeed are relatively short.
This phrase appeared first in 1985 when the Malaysian and Singapore markets bounced back after a strong decrease and continued to weaken again. Now we will review how this pattern works and how we can take advantage of it.
So, what is a dead cat bounce?
Usually, trends are followed by short pullbacks or corrections – small price recoveries. The dead cat bounce means a slight price recovery in a falling market. Usually, it constitutes of 3 parts:
1. The asset price starts to decline and falls by 30% in just a couple of trading days.
2. Then, the price bounces back and recovers a small part of the losses.
3. Finally, it continues to fall further, losing even more than before.
Picture 1. Example of a dead cat bounce
So, we can conclude that the dead cat bounce is a continuation pattern. It implies that after a short recovery, the price will continue to move down. It can be confirmed when the price resumes its downward movement and reaches an even lower level than the previous value.
Good, but how can I take advantage of this?
Firstly, use technical and fundamental analysis to confirm whether it is indeed the dead cat bounce. The price may continue to rise after the sharp fall. You need to estimate the length of bounce and the possible price development afterward.
You can use indicators to confirm this. For example, a mixture of the Moving Average, MACD, and the RSI indicators would be an excellent choice in this situation. All of them are available on IronTrade.
Usually, such a pattern is observed in longer time frames when the market is in recession. However, don’t hesitate to use it in short-term periods as well. Initially, it was a stock-trading pattern, but it can be applied to Forex currencies when they experience a strong price decline.
If you usually choose a short expiration time, then you can use the pattern to predict when the price will bounce up. Surely it implies an element of risk because you need to carefully predict the bounce’s length before the price continues to fall.
If you prefer a long expiration time, then you can open a “downwards trade” at a higher price expecting that it will go down. In this case, you also should think about possible times of recovery.
Anyway, please remember that no strategy can guarantee 100% results. Even this strategy may be a bit hard because it is difficult to know the price behavior beforehand. Using different indicators or reading economic news is always a good idea because it will give you additional support for your strategy. Finally, don’t forget to try your new knowledge in action on IronTrade.
