Sunday, January 22, 2012

E-Mini Trading: The Dead Cat Bounce

I have heard this particular expression used often and in a variety of e-mini trading situations and thought it might be useful to clarify exactly what e-mini traders are referring to when they described a "dead cat bounce." Since this term is indelicate, at best, and tasteless at worst, we shall abbreviate it DCB. Nonetheless, recognizing this formation can keep money in your pocket, as it occurs often and can be a tempting trade. For some, this trading formation is a chance to make some quick money. In any event, it is helpful to know how to identify a DCB and react accordingly.

As I mentioned in the opening paragraph, the term "dead cat bounce" is often used in New York and Chicago. There are two individuals credited with coining this phrase. It was first written in the Financial Times in 1985 by Chris Sherwell when he described a sharp decline on the Singapore stock market. It was also mentioned by Raymond DeVore, Jr., who is a research analyst, and commissioned a bumper sticker stating "Beware the Dead Cat Bounce" in 1986. Though the history is claimed by both individuals, the fact is that the term has been around for more than 20 years and increased in popularity, it seems, with each passing year.

A DCB occurs after a violent downward spike in market price caused by an adverse news event announcement. At some point, sometimes after as much as a 20% decline, the market finds its initial bottom and rallies for a short period of time, say 5 to 10 bars, more or less. After this short rally, the market generally resumes its downward trajectory until it finds another bottom, which may or may not be a true bottom. In theory, the longer the first leg down extends the higher the DCB will extend. A skilled trader can trade the DCB and take a quick profit, while a novice or unskilled trader may try to make the same trade and stay in a the trade too long and find himself/herself careening downward at a high rate of speed as the market resumes its downward spiral. In short, trading this bounce is strictly for experienced traders and should be avoided by less experienced traders. There are several reasons inexperienced traders fail at this trade:

· They stay in the trade too long because of sheer greed.

· They stay in this trade too long because their momentum indicators have switched to a bullish reading.

· They stay in a trade too long because they misinterpret the rising volume levels as a positive confirmation of trend change instead of being profit taking.

In summary, we have given a reasonably accurate definition of the dead cat bounce (DCB), along with a less offensive an acronym, and described the conditions from which it arises. We have also cautioned inexperienced traders to avoid trading this formation and given solid reasons to avoid trading a DCB. Finally, we have noted that experienced and nimble traders can sometimes grab a quick profit when trading the DCB.

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3 comments:

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