How to Trade a Dead Cat Bounce | Fading the Top

One of the surest signs that there is a bear market is when there's a dead cat bounce. Selling short at the end of one can provide quick trade setups when markets are in a downtrend.

What is a dead cat bounce?

The name crudely likens the price of action of the market to a cat. It is when the price of an asset experiences a sharp recovery during a downtrend, which proves to be short-lived and soon after the downtrend continues. 

The dead cat bounce can be an incredibly rewarding setup to trade. However, it is also a dangerous pattern given that it can often mislead new traders and lure them into thinking a bullish reversal is taking place. This is why it is vital that new traders familiarise themselves with the setup and learn to identify dead cat bounces in live market conditions. 

What defines a dead cat bounce?

Unlike classical technical analysis price patterns like the head and shoulders top or double bottom, there is no specific structure that defines a dead cat bounce. The criteria are simply identifying a bullish corrective move happening within a bear trend. Specifically, there are two characteristics to help spot one.

1) The trend of the market is down so the DCB moves counter to the direction of the market.

2) A DCB is always a strong impulsive move (they can therefore often times start with a long-tailed candle, signalling the swift reversal in sentiment which occurs during the downtrend to lead price higher).  The name itself implies the velocity of the reversal,  ie not a slow, steady recovery. A dead cat bounce will stand out due to the strength of the initial reversal higher. 

What causes a dead cat bounce?

There can be many different drivers behind the move. Short-covering (ie short-sellers exiting trades), a reaction to a data release or event, technical inputs etc; are all valid catalysts for a dead cat bounce.

Whatever the driver, the premise is the same; a sharp reversal higher which ultimately fails and sees the downtrend resuming. It's with that in mind that any trading setup will best capitalise on this market phenomenon. 

Trading the Dead Cat Bounce

The below two methods focus on selling the top or 'fading' the dead cat bounce by selling short rather than trying to catch the initial move.

1) Fading the bounce at resistance

The first method we can use for trading the dead cat bounce relies on a simple understanding of market structure. Support and resistance levels are an incredibly versatile tool for helping identify great trade entries and with the dead cat bounce, they are particularly useful. So, when we are using support and resistance for trading the dead cat bounce, essentially what we want to do is identify a solid resistance level and look to fade the bounce as price tests the resistance level. 

 

Source: FlowBank / TradingView

In a bear trend, this method works particularly well because typically what we are doing is fading the correction as price retests broken swing lows within the trend. These areas tend to be regions where trend traders and longer-term players re-enter the market or reload positions and so they are generally a strong option for setting short entries, anticipating the failure of the bullish move and a continuation lower.  The setup can also occur where the reversal sees price trading back up to retest a prior swing high, creating a double top formation. 

Now, in terms of actually entering the trade, there are options. More aggressive traders can simply opt to trade the level strike, entering a short position as the price tests the readily marked resistance level. More conservative traders can wait for price action confirmation. So, in this scenario, we would wait for reversal candles to form as price tests the resistance, such as bearish pin bars or bearish engulfing candles, entering a short position as the price reverses lower from these candles. 

Technical Indicators for a DCB

The next method we can use relies on technical indicators. Given the nature of the setup; attempting to trade the failure of a bullish correction and the resumption of the downtrend, momentum studies are particularly useful.  The stochastics indicator is great choice for helping us trade the dead cat bounce.

2) Overbought Stochastics

When using the stochastics indicator, essentially what we want to do is wait for the indicator to move above the overbought threshold, signalling that bullish momentum is overstretched to the topside and vulnerable to a bearish reversal. We therefore want to wait for the indicator to then cross back under the overbought threshold, signalling that momentum is turning lower and price is beginning its reversal lower. When using this method we can either rely on the indicator solely, or look to combine the indicator reading with another method, such as support and resistance. 

So, in this case we would look for price to trade back up and test a resistance level and then look to the indicator to give us our entry as the stochastics hits overbought and then turns lower. This is a powerful yet simple way of designing a dual-criteria trading method whereby we would only take the trade when both signals are present; price hits resistance and the stochastics has hit overbought territory. 

Source: TradingView / FlowBank

Live Example in the S&P 500

We’ve actually just seen a great example of this setup in the S&P 500 recently. You can see over Mark we saw price reversing sharply higher, only to make a false breakout above the prior swing high before the price began its reversal lower. 

 

Source: FlowBank / TradingView

Now as the index tries to rebound off the last week's lows, we can consider some possible scenarios for what happens next. Should the index hold its ground above 3800 it could set the stage for another DCB, whereby prior resistance at 4200 is tested before another possible leg lower.

Considerations when trading the dead cat bounce

Given the nature of this pattern, we are looking for a bullish correction to fail and the longer-term downtrend to resume, the obvious risk is that the move is actually the start of a broader bullish reversal.

As with all trading strategies, there will be instances when the setup fails. So, with this in mind, it’s important to always manage our risk and ensure we are trading with well-placed stop losses and appropriate position size.  

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