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“If you drop it high enough, even a dead cat will bounce back” – that's what an old Wall Street saying goes. The idea is that even after a deep recession, markets rebound and prices rise, at least temporarily. This term was first introduced in 1985, when the stock markets in Malaysia and Singapore rebounded from a severe recession, but continued to decline thereafter. Let's see how a model with such an eccentric name works and how traders can use it in their strategies.

What is a "dead cat bounce"?

A trend market is almost always accompanied by small declines, temporary price recoveries. The “dead cat rebound” is a short rally in price in a declining market. According to Thomas N. Bulkowski and his Encyclopedia of Chart Patterns, the “dead cat rebound” occurs in three stages. First, the price of the asset drops about 30% in a few trading sessions, then prices rebound, recouping some of their loss. The third phase is when the prices fall again, losing all their gains and more.

A "dead cat rebound" on WTI crude oil

The "dead cat rebound" is a continuation pattern, which means that after the short rally in price, it continues to decline. It is only considered confirmed if the price resumes its downtrend and hits a new low, lower than its previous value.

How to trade this trend?

At first, the trend may look like a trend reversal, as the price may simply continue to rise after the sharp drop. This is why traders should use technical and fundamental analysis tools in order to estimate the duration of the rebound and possible price movement thereafter. Traders can incorporate both oscillators and trend indicators in order to form a well-informed opinion. For example, a combination of moving average, MACD, and RSI indicator can be applied.

The “dead cat rebound” is normally seen over longer periods of time as the market is in recession. However, both short and long term traders can use it. This was originally a stock trading model, but it can be universally applied to any asset that shows a sharp drop in price.

Short term traders may attempt to take advantage of the short term rebound and “ride” the uptrend. However, it takes a well-thought-out risk management strategy and general self-control to exit the trade in time, before the price hits a new low. Traders can set a tight stop-loss or a trailing stop-loss in order to manage risk.

Long-term traders may find an opportunity in the rebound to enter a short position at a higher price, but they should be careful and differentiate a "dead cat rebound" from a trend reversal.

Whatever your strategy, remember that there is no one model that will guarantee 100% results. The "dead cat" strategy can be particularly tricky, as it is quite difficult to know in advance the behavior of prices. It may be a good idea to use additional tools like indicators and to seek additional information like economic news for additional conformations.

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Source: IQOption blog (blog.iqoption.com) 2020-10-12 11:00:12
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