A dead cat bounce is a short-lived rally after a steep price drop, before the decline carries on. It looks like a recovery, which is why it traps buyers. In 2022, the S&P 500 climbed about 17% from mid-June to mid-August, then fell to a new low for the year. Anyone who bought at the August top was down about 17% by mid-October.
You can only confirm a dead cat bounce in hindsight, because a real recovery starts the same way. While a rebound is underway, watch for four warning signs:
- the rally stalls below the last peak on the way down (the last “lower high”);
- price turns back down at the old support level, the floor that broke during the fall;
- trading volume on the rally is light;
- the bad news behind the fall hasn’t improved.
What does a dead cat bounce look like?
On a chart, the dead cat bounce pattern is a sharp drop, a partial recovery and then a fall to a lower price. Take a hypothetical stock that falls from $100 to $70, rebounds to $82, then drops to $65.
The rebound from $70 to $82 is a gain of about 17.1%, a big win for anyone who bought at $70. Yet the stock is still 18% below where it started.
A bounce from $70 to $82, then a new low at $65.
At $82, nobody knows the stock will fall to $65. The rally becomes a dead cat bounce only when it fails, and here the proof comes when price breaks below the $70 low. By the time it reaches $65, anyone who bought at $82 is down $17 a share, about 21%.
Why do prices bounce during a downtrend?
Prices bounce because some traders buy even when the outlook hasn’t changed. Short sellers, who profit when prices fall, buy shares back to lock in gains (short covering). Bargain hunters see a lower price and expect a recovery. News that is merely less bad than feared can also spark buying.
None of these means the business has improved, and the chart alone won’t tell you which one is driving a rally.
Warning signs: dead cat bounce vs a reversal
A reversal turns a downtrend into an uptrend, while a dead cat bounce only pauses the decline. Run the four checks below on the timeframe you trade.
Does the rally break the last lower high?
If it doesn’t, that’s the first warning sign. In a downtrend, each peak is lower than the one before (lower highs), and so is each dip (lower lows). A rally that stalls below the latest peak leaves that staircase intact. In the chart above, the bounce stops at $82, well short of the last peak on the way down.
A break above that peak, followed by a pullback that holds above the recent low, is stronger evidence of a reversal, though even a clean break can fail.
What happens at the level that broke?
It can turn from a floor into a ceiling. That level is the old support, the price where buyers had stopped earlier falls. If the rally turns down when it gets back there, that’s a warning sign; if price climbs above it and holds on the next dip, a recovery is more likely.
Mark the level before price gets there, and don’t redraw it after every failed test. Our guide to support and resistance shows how to choose it.
Do volume and momentum back the move?
Not if the rally comes on light volume. Compare the rally’s volume with the sell-off before it. Light volume means few buyers are taking part. Our guide to using trading volume explains how to read it.
The Relative Strength Index (RSI) measures momentum on a scale of 0 to 100, and readings below 30 are traditionally called oversold. In a strong downtrend, RSI can stay oversold for long periods, so a climb out of that zone is weak evidence on its own.
Has the news behind the fall improved?
If it hasn’t, a rising share price has little to stand on. Go back to the announcement that started the slide. If the company cut its earnings forecast, has it reported anything since that improves the outlook?
Dead cat bounce example: S&P 500 in 2022 vs 2020
The index bounced hard in both years, but only the 2020 rally lasted. The figures are daily closes from FRED, excluding dividends and intraday swings.
Two S&P 500 rallies, only one lasted.
2022Jun 1 – Oct 12
2020Feb 19 – Aug 18
2022: a 17% rally that failed
From June 16 to August 16, 2022, the index rose from 3,666.77 to 4,305.20, a gain of about 17.4%. By October 12, it had closed at 3,577.03, about 2.4% below its June 16 close, so the whole rally was gone. Yet on August 16, a 17% gain looked a lot like the start of a recovery.
2020: a 31% rebound that kept going
The index fell about 34% in just over a month, from 3,386.15 on February 19 to 2,237.40 on March 23, 2020. By April 29, it had climbed to 2,939.51, about 31.4% above that low.
There were pullbacks, but it didn’t close below the March 23 low again, and on August 18 it closed at 3,389.78, just above where the fall began. Treating every rally after a crash as a dead cat bounce would have meant missing, or betting against, that recovery.
How to handle a suspected dead cat bounce
Treat the rebound as unproven, and decide in advance which price would change your mind.
If you’re already holding
Go back to why you bought. If it was for a short-term recovery, decide now what would prove you wrong, such as a close below the recent low. If you own the shares for the business, review the earnings outlook and valuation as well as the chart.
Waiting to get back to your purchase price feels natural, but the market doesn’t know what you paid. Ask whether the position still fits your plan at today’s price.
If you’re thinking of buying
Before you enter, decide what evidence you need, such as a break above the last lower high and a pullback that holds. Write down which high and low count.
More evidence usually means a higher entry price. Check that you still have room to the next resistance level, where selling has stopped earlier rallies. If your stop-loss is far below and resistance is close above, waiting hasn’t given you a better trade. Our guide to buying the dip works through the entry, stop and position size.
If you’re thinking of shorting
Shorting means selling borrowed shares now and buying them back later, hoping to pay less. Shorting a rebound just because it looks too big can put you on the wrong side of a real recovery. A safer approach is to wait until the rally stalls below the last lower high and starts to turn down. A stock short costs borrowing fees and needs margin, and a CFD short usually carries an overnight financing fee for each night you hold it, so check the instrument’s terms.
In our example, the bounce stalls at $82 and the price starts to fall. A trader sells 10 shares short at $78, sets a stop-loss at $84, just above the bounce high, and plans to buy back at $70, the earlier low. Before entering, the trader compares what the trade risks with what it could make:
- Risk: $84 − $78 = $6 a share, or $60 on 10 shares.
- Reward: $78 − $70 = $8 a share, or $80 on 10 shares.
- Reward-to-risk: $80 ÷ $60 = about 1.33, so the trade stands to make $1.33 for every $1 it risks, before costs.
That’s a much thinner edge than the chart’s slide from $100 to $65 suggests. Our guide to the risk/reward ratio explains how to judge it.
A stop-loss doesn’t guarantee your exit price. An ordinary stop order becomes a market order once triggered and fills at the next available price. If the stock opens at $87 after an overnight jump (a gap), the loss is $9 a share, or $90 before costs, 50% more than planned. Size every short so that even a gap-sized loss wouldn’t hurt your account.
Common mistakes when judging a bounce
- Switching timeframes to defend a position: if your setup depends on daily resistance, a five-minute breakout doesn’t cancel that level. Decide in advance which timeframe governs the trade.
- Studying only the bounces that failed: if you search old charts for dead cat bounces, you’ll find only rallies you already know collapsed. To test an entry rule fairly, include every rally that met it at the time, the lasting recoveries too, with realistic costs and losing exits. Then forward-test the same rule on live prices in a demo account before you risk money.