Dead Cat Bounce - A Spooky Pattern

31 Okt 2019

Introduction

Its halloween ! And i felt like making a post about spooky stuff related to trading. I wanted to discuss about what is a zombie economy but i clearly don't have the time nor the experience to do that. So instead i'll talk about the dead cat bounce, a pattern commonly found in downtrending (bearish) markets, this pattern is also known as "Bear market rally".

We'll describe the pattern, its causes, its upsides and downsides. Unfortunately my knowledge on price patterns is relatively low, if you feel the need to correct me leave a comment.


Brace Yourself The Dead Cat Is Coming !

A dead cat bounce is a pattern appearing during downtrends, this pattern is associated to a brief upper movement (recovery) followed by a continuation of the downtrend, therefore the pattern can be classified as a retracement.



Terminology

The term "dead cat bounce" comes from the saying that "Even a dead cat will bounce if it falls from a great height", physics won't necessarily agree with that but the phrase can be deconstructed in order to explain the pattern described :

"Even a dead cat will bounce if it falls from a great height"

- Dead : Refer to the downtrend.

- Bounce : Describe the motion of the pattern.

- Great Height : Emphasis on the prior downtrending movement magnitude.


Causes Of A Dead Cat Bounce

Causes of certain motions in prices fluctuations are hard to describe, the structures (trends, cycles/seasonality...)/patterns in price can be either : stochastic (the pattern is formed because of a realizations of random fluctuations) or deterministic (the pattern is formed because of certain external causes).

A deterministic cause of a dead cat bounce is described by Kolja Johannsen as investors taking excessive risk and unprofitable positions in order to recover an initial loss in a declining market, the accumulations of those investors as well as investors believing in a reversal participate in the creation of this upward movement.


Upsides Of Dead Cat Bounces

When a security allow short positions, dead cat bounces allow late investors to go with the downtrend from a more interesting point.

In stock markets they can allow investors to potentially profit from the bounce, however such strategy require extremely precise timing, one must make sure to sell at the maximum of the retracement. Such methodology make the investor exposed to the continuity of the downtrend, thus making the risk reward extremely uninteresting.


Downsides Of Dead Cat Bounces

A dead cat bounce like any retracement is a parasitic motion in the main trend, they might make investors believe in a reversal, in a mathematical standpoint those parasitic motions affect technical indicators, this is where robustness is required, robust indicators might be able to ignore the dead cat bounce.

The dead cat bounce deform the main trend and therefore can add complexity to a trend model.



Above a simple linear trend, we can describe it as a simple line + white noise, such equations are called equations of motions. However describing a dead cat bounce mathematically might require additional complexity.

Detecting/Avoiding Dead Cat Bounces

Classifying upward movements as either a retracement or reversal is no easy task, however we can still make use of several tools in order to detect or avoid dead cat bounces.

The first tool being filters, filtering a dead cat bounce can be made using a low pass filters (filter noise/cyclic components) or notch filters (filter cyclic components). The filter setting must be adjusted in order to be able to filter the pattern.



Blackman filter of period 100



Rolling max/min with period 100 (Donchian channels), no highest low have been detected here, witch allow us to remain with the main trend, note that rolling max/min are also low pass filter.



Another approach might be made using support and resistances, we can see that both the minimum/maximum of the dead cat bounce are both pullbacks, altho this observation is clearly insignificant and lack logic (like most technical analysis approach) unlike the previously discussed method.


Conclusions

Altho my experience on patterns is low, i hope i could teach you something new in this post. Dead cat bounces make parts of those disruptive patterns that might make us take a bad position, we have also seen that they can be made from the emotional bias from investors, that is premature re-entering of a declining market, which is never a good idea. Finally we discussed methods to filter/detect such pattern.

Like most patterns in technical analysis their detection/interpretation is relatively subjective to the user, the uniformity/complexity of stock market prices make detection of patterns quite complex. But the most important thing to take from this post is that strategies robust to retracements can help the investor make better decisions, going long because of a dead cat bounce is not a enjoyable experience, that cat wasn't so alive in the end...Happy Halloween !