Dead Cat Bounce: A Complete Guide

The idea of a “dead cat bounce” might sound somewhat alarming, but as long as you hear it mentioned within the context of trading, it refers to a particular phenomenon in the stock market.

What are the Causes?

A bounce happens when pessimism begins to set into a bear market. If the market continuously displays a downward trend for weeks on end, the conditions for a bounce begin to foster — and it’s made possible by the way different types of traders act.

The Economics at Play

As you’re probably well aware, the two main forces at play in economics are supply and demand In the case of a dead cat bounce, the supply force is made up of the investors who are shorting, while demand is fuelled by investors who believe the stock price is about to increase.

The Market Psychology

Greed can mean some traders don’t want to pat themselves on the back and bow out when a stock they traded at the bottom increases in value by 10% — or even 20%. So they hold for too long and end up making a loss.

Real-World Examples

- The Great Depression - The S&P 500 in 1974 - The NASDAQ in 2000

Reversal or Bounce?

Spotting the difference between a reversal and a bounce is one of the toughest elements of this type of trading, and I wish I could give you a surefire trick for how to do it. Unfortunately, I can’t, other than recommending you to use your knowledge of market fundamentals and having self-knowledge of your trading style and psychology.

How to Hedge Yourself

After stock prices fall dramatically then begin to increase again, making a short can seem like an attractive prospect. At this point, it’s essential to make sure you don’t misread the bounce as a reversal putting at risk more capital than is planned.

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