What bouncing dead cats can teach traders about markets

WHEN it comes to free-falling stocks, as the adage goes, if you can keep your head while all around you are losing theirs, you have probably failed to properly grasp the situation. However, when the market starts to dive, you should keep an eye out for stock prices to do what has long been known by traders as a “dead cat bounce.”

Though this isn’t an experiment to be carried out with the recently demised family moggy, this unsavoury analogy rests on the observation that an expired cat, if thrown out of the window, may bounce a little upon interaction with terra firma.

A similar thing happens with stocks, where you will often see a market undergo a rally after a sharp fall. Technical analysis describes a dead cat bounce as a continuation pattern that looks in the beginning like a reversal pattern. It begins with a downward move followed by a significant price retracement. The price fails to continue upward and instead falls again downwards, and exceeds the prior low.

With the FTSE in a generally healthy and stable state, there are not a lot of current examples of proverbial moggys that have kicked the bucket. One to have gone the way of the gravity inclined feline is Sainsbury’s supermarkets which went from 395p early in the year down to 330p in March before briefly bouncing up to 348p. However, the biggest kitty to run down the curtain and join the choir invisible is BP. As you can see from the chart below, the stock price dived following the Gulf of Mexico oil spill in May last year, losing more than half of its price in 2 months, before a soggy rebound towards the end of August.

The difficulty with dead cat bounces is that they tend to be something observed in hindsight rather than spotted at the time and so the dilemma arises as to whether the cat has miraculously survived or if the move is indeed a temporary retracement before the kitty heads back towards the pavement.

This is especially true in currency markets. According to Richard Wiltshire, senior trader at ETX Capital, “an example of dead cat bounces have been in dollar-Swiss franc over the last few months where overall we have been in a relatively strong downtrend although you will see there have been decent retracements causing the market to question whether a bottom has been put in place and the trend coming to an end or it’s a temporary ‘relief’ rally in an ongoing downtrend.”

Because of the difficulty of identifying if you have a rebounding ex-cat on your hands or a real, live rally, David Jones, market analyst for IG Index, advises that you should not get sucked into a dead-cat bounce: “You shouldn’t be a buyer when you see a retracement. Instead you should sell short in the bounce back in anticipation of further losses.” With this in mind, traders should see felines falling from the sky as a helpful sign of things to come.

No cats were harmed in the writing of this article.