What Is a Dead Cat Bounce?

A dead cat bounce can be an opportunity for profit or a good chance to get suckered into a bad stock. Here's what it means, and how to look out for one.
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Shares in your favorite stock have gone down week after week. The company missed its earnings for both of the last quarters. The corporate retreat is scheduled for a non-extradition country, every smart device within three blocks of their headquarters catches fire, and the company’s latest product automatically signs users up for Facebook. (FB) - Get Report

This ship is going down.

Then, somehow, the numbers turn around. From losing 10%, 15%, 20% day after day, Monday morning dawns and your stock actually goes up. It does so again the following day. You start thinking that maybe you shouldn’t sell. Maybe everything will be all right.

Or maybe it’s just a dead cat bounce.

What Is a Dead Cat Bounce?

A dead cat bounce happens when a declining stock suddenly regains some of its value, only to fall even further soon after. It’s an illusory gain brought on by short term fluctuations in the market. The company hasn’t gotten any stronger. The stock just enjoyed a few days of unearned growth.

Both of these elements are essential to the definition.

The stock price must be falling before the gain in value. A dead cat bounce doesn’t apply to short term bursts of stronger gains for an otherwise strong stock. The gains must also be temporary. A dead cat bounce does not apply to an actual recovery. During a dead cat bounce, prices rally for a brief period of time then resume a consistent downward trend.

Finally, this does not apply to mid-day volatility. The term “dead cat bounce” generally applies to daily trading activity. Traders typically won’t refer to this when a stock’s price varies up and down over the course of a single day.

For ease of language, this article will refer to dead cat bounces in the context of stock trades, but the term can apply widely. An individual stock, bond or commodity can experience one; so, too, can industries or even an entire stock market. The term dead cat bounce can refer to any short term, illusory gain in value during an otherwise general decline.

The term comes from an old expression that even a dead cat will bounce once.

Dead Cat Bounce Example

Say that Grow Co. trades at $100 per share. A dead cat bounce might look like this:

  • Grow Co. is worth $100 per share on January 1.
  • Over the next three months its price declines to $75.
  • From April 1 until April 7, Grow Co.’s price ticks back up to $85.
  • On April 8 the price begins falling again, declining to $50 before stabilizing.

This is a dead cat bounce in action. The stock’s price arrested its fall briefly, before tumbling lower than its previous low.

How Can You Tell?

It’s important to note that there is no precise definition for a dead cat bounce. Generally speaking the elements are:

  • The stock’s price has fallen consistently;
  • The stock regains value again, but for a short time;
  • The stock loses value again, falling below its previous low point.

This can make it difficult to spot a dead cat bounce when one is happening.

The truth is, there’s no way to tell the difference between a dead cat bounce, a rally and a revaluation until after the fact.

If the price fluctuates around some mid-range price, it indicates that the market has found a new stable value for this stock. In our example above, say that Grow Co.’s price declines to $75 then ticks back up to $85. It then generally moves within a range of $70 and $80. In this case Grow Co. has not experienced a dead cat bounce. It has found a new stable value.

At the same time, at first a dead cat bounce appears to be a rally. In some cases this might be true. The only difference between a bounce and a rally is when the stock turns around and comes back down to earth. Typically the only way to determine this in advance is by studying the fundamentals of the underlying asset (the company in the case of a stock).

If you think the company is currently undervalued, price gains might reflect a rally. If you think the company remains weak, it is likely an illusion.

How Does A Dead Cat Bounce Happen?

Typically, a dead cat bounce reflects short-term speculation.

Traders, particularly short-term traders who work over the course of days or less, will often buy up declining assets. They will do this for a variety of reasons. Most often it will be to capitalize on short-term fluctuations, hoping that the stock will regain one or two dollars in the course of a day’s trading.

In some cases this interest can cause the stock’s price to tick back up. In turn, this may generate interest from other buyers who jump in when they see the stock’s price regain value. This can cause a cycle of buying and price increases until, eventually, traders sell the stock back off again.

A dead cat bounce can also happen when short sellers exit their positions.

If a company looks overvalued, many traders will short-sell its stock, expecting its price to go down. However, exiting a short sale position involves buying the stock. (A short seller borrows shares of stocks, immediately sells them, then buys them back to return the shares they borrowed.) When multiple traders exit a short-sale position, it causes a flurry of buying. Any time the market sees an uptick in buying, it causes a short term rise in prices. Sometimes this can bring more traders into the market, causing the stock’s price to rise further.

Like with speculation, however, the gains are illusory. The underlying company hasn’t gained any value. Traders have just fled in droves.