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Dead Cat Bounce

Intermediate
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The term "dead cat bounce" is a rather nice and colorful one, and you may hear it quite often, particularly during high market volatility. It is a phenomenon, mainly in Wall Street, where there is a temporary recovery in the price of an asset, which is otherwise in a declining trend, followed by a continuation of the decline. The term comes from the idea that even a dead cat will bounce if it falls from a great height. It is not only crucial for novice traders but also for experienced ones, as this concept can help in making more informed investment decisions.

What Is a Dead Cat Bounce?

A dead cat bounce occurs when an asset that has been experiencing a prolonged decline suddenly shows a short-term recovery in its price. This recovery can mislead investors into thinking that the asset has hit its lowest point and is on its way back up. However, this optimism is often short-lived, as the price soon resumes its downward trajectory. This pattern is considered a continuation pattern in technical analysis, meaning that after the brief upward movement, the asset's price will likely continue to fall.

Examples of dead cat bounces include the aftermath of the dot-com bubble in the early 2000s, where tech stocks such as Cisco Systems experienced recoveries in the short term between a prolonged decline. Similar patterns were observed during the global financial crisis 2008, where brief market recoveries gave false hope to investors. A recent example is the COVID-19 pandemic in early 2020 when the U.S. markets took falls and then bounced—only to continue on a downward spiral.

Several factors can trigger a dead cat bounce. One common reason is short covering, where traders who have bet against the asset start buying it back to close their positions, temporarily driving up the price. Another factor is the influx of bullish investors who mistakenly believe that the asset has reached its bottom and start buying, hoping for a rebound. Additionally, technical indicators might signal that the asset is oversold, prompting short-term buying activity.

The dead cat bounce is often a hard thing to know in real time because it seems, more or less, like a natural recovery when it initially takes place. This explains why this is one of the hardest things for traders and investors to deal with. Most investors become trapped in these false rallies, buying into the short-lived recovery just to grapple with further losses as the downtrend unfolds. Again, it becomes necessary to do a thorough technical and fundamental analysis to make a more appropriate assessment of the market conditions.

For long-term investors, it's essential to know a dead cat bounce when you see one in order not to react mistakenly to short-term market moves. Diversified portfolios and long-term investment strategies act as a hedge against such volatility and deceiving recoveries characteristic of falling markets.

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