Trading strategy with a dead cat bounce

Trading strategy with a dead cat bounce

2019-11-11 • Updated

Introduction

Imagine that you trade your favorite currency pair in the long-lasted bear market. Suddenly, the price has started to go up. However, don’t get confused too quickly. There is a possibility that you faced with a so-called dead cat bounce. Wait, don’t be scared, FBS carries about animals and the environment! This is just the name of the short-term retracements. But they may actually be “deadly” for you, especially if you do not know how to trade during this situation and how to divide such bounce from the actual reversal.  In the article, we provide you the explanation of the dead cat bounce and the trading strategy, which may be used to trade during this kind of reversal.

What is a dead cat bounce?

The meaning behind this phrase is simple: even the dead cat may bounce if the speed is fast enough. The term “dead cat bounce” is used when the market rebounds within a prolonged downward movement. However, such a rebound usually lasts for a short period of time and bears take over the market very quickly.  While the market goes up and down, different forms of retracements are always possible. That is why these situations may be used by some smart traders to earn money.

Spotting a dead cat bounce

At first, you need to divide such rebound from an actual reversal. Here's the brief instruction on how you can do it. 

  • Be aware of the current trend.

The strong bearish trend usually lasts for a long period of time.  You can learn how to define a downtrend here

  • Know the upcoming events in the market.

If there is an important announcement by the central banks (Fed, for instance) or there is any crucial news during the downtrend, the possibility of a dead cat bounce’s appearance is likely.

  • Pay attention to the technical indicators.

There are several trend indicators which may help with identifying the current direction of the price.  They include parabolic SAR, Bollinger bands, standard deviation, ADX, and moving averages. You can find out how to apply them correctly from the Forex guidebook.

Sometimes oscillator indicators may signal the reversal, too. For example, if RSI falls into the oversold zone, we can expect the price to go up.  

If some of these conditions are not met, then you are probably facing the fake reversal, known as a dead cat bounce.

Trading a dead cat bounce

When you identify a dead cat bounce, you need to open a short position when the pair breaks the last bottom level before a dead cat bounce. It’s highly important to pay attention to the price moves, as you may skip the right time to enter the market.

Below we pointed out the trading strategy with a dead cat bounce.

  1. Identify a strong bearish trend.
  2. Check the trend indicators: if parabolic SAR and Bollinger bands show the downtrend for the pair, it may continue.
  3. Wait for the price to break the trend line and go up.
  4. When a reversal occurs during the downtrend but the indicators signal the bearish market, wait for the price to go down.
  5. Mark the level of the last bottom before a dead cat bounce.
  6. If the candle closes below the last bottom, it confirms a dead cat bounce and you can open a short position.
  7. Do not forget about stop losses! If bulls take over the market, the price will go further up and you may lose money. Place it above the previous high.
  8. Stay in the market until the bearish pressure continues.

Example

Let’s look at the 4-hour chart of EUR/USD. Here we can see, that the price for the pair went up, despite the downtrend and broke the trend line. In addition, that parabolic SAR did not signal a reversal as well as Bollinger bands. RSI was placed in the middle, which also might be interpreted as the continuation of the trend. After the pair fell below its last low at 1.1499, a dead cat bounce was confirmed and we could place a short order at this level. At the same time, we placed a stop-loss order above the last high at 1.1541.

EURUSDH4.png

 Be aware, that you may face an actual reversal. On the daily chart of AUD/USD below, you can see that the jump of the price occurred. However, despite the bearish candlestick which was formed after the rise and pulled the pair lower than its previous bottom, the market changed the trend.  If we look at RSI, it fell close to the oversold zone. That is why we recommend you to analyze your further steps in the market more thoughtfully. In case you opened a short position, the stop loss placed above the top at 0.7069 would save you from an unfortunate outcome.

audusdd.png

 Note: The phrase “time is money” is very suitable for this kind of strategy. If you do not enter the market at the right time, you will probably miss a great trading opportunity.

 

Conclusion

A dead cat bounce may be tricky, that is why you should trade during this situation very attentively.  The main advice you need to follow is to be patient and wait for more confirmations on the chart.

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