A dead cat bounce is a short trading strategy unique to gap-down stocks. A dead cat bounce is a significant psychological market event that is triggered by a significant market event that causes a wave of selling. Even though the stock may move up a little bit, it is really just an opportunity for sellers to get out.
The general idea behind a dead cat bounce is a stock that gaps down in overnight trading, continues to go down at the opening bell but then rallies to a point near the opening price before continuing its downward trend.
For a dead cat bounce to exist a few conditions need to be met.
The stock must show a significant gap from the prior day’s closing price. If the stock is not considered to be volatile, many traders use 5% as a guideline. For volatile stocks, they usually look for a much larger gap.
The stock must decline for at least five minutes once trading begins. If the price doesn’t keep falling, there can’t be a bounce.
The stock will then start to rally in an area close to its opening price. This will typically represent a resistance level. This is where traders should be looking to take a short position.
The stock will then fall again. This is the confirmation that the stock is indeed having a dead cat bounce.