One of the most colorful terms in investing comes into play after a stock hits its lows and then rebounds a bit. But just because you have heard traders say “That was a dead-cat bounce” doesn’t mean you know what they were talking about.

Derived from the idea that “even a dead cat will bounce if it’s dropped from high enough,” a dead-cat bounce is occurs when there has been a temporary rebound after if a stock has a prolonged stretch of bearishness. In essence, it’s a fake-out reversal, which can trick traders looking to get into the stock or exchange-traded fund (ETF) at a big discount.

A real reversal occurs when the security really changes course. UIn a dead-cat bounce, the rebound is small, and is only a temporary respite from the selling. Let’s examine the differences.

Dead-Cat Bounce

The dead cat here is the stock/ETF. It has fallen enough, it takes a temporary rebound, but then — because it’s not actually showing signs of life — it falls again.

The signs of a dead-cat bounce can be spotted by looking to see whether the security has been in a strong bearish trend, or downtrend. Thereafter, look for an increase in its price and a break above the upper downtrend. The next price action to look for is a pull-back into the down channel.

Let’s take a look at an example.

Source: TradingView

In this chart on Perrigo (PRGO), the stock trades in a downtrend for months, but then has an uptrend ahead of its earnings release in late February 2017. In this annotated chart, the stock rises above its upper downtrend line, but then gaps down after its earnings release, confirming that this was a dead-cat situation and that more bearish trading was ahead.

If you were able to short PRGO after its earnings release and the dead-cat bounce, you would have profited from the price action. But this is all in hindsight. With dead-cat bounces, your timing needs to be near perfect, and you’ll need to study this pattern and do your homework before going out and testing this strategy with real money.

Reversal

On the other hand, there are times when trends reverse. Sure, you’ve heard people say “The trend is your friend,” but trends do fail and break down in the event of a catalyst, and a security is not always trending.

A reversal is a change in the current price trend; technically it can be a bullish or bearish change. Obviously, when comparing it to a dead-cat bounce, you are looking for a bearish trend to turn bullish, for the stock to break above the upper downtrend line. (If the security has been on a bullish trend, you spot a reversal by looking for the stock to trade to break the lower uptrend line.)

Here’s an example:

Source: TradingView

Dynegy (DYN) was recently in a downtrend. It was hard to gauge whether this would be a dead-cat bounce or a reversal, but there was a positive catalyst, attributed to buyout rumors. Thereafter, the stock reversed and broke out of its downtrend. Here’s a look at what happened.

Source: TradingView

Final Thoughts

A dead-cat bounce and reversal look similar when a stock is in a strong downtrend. That said, understand how to spot the difference before trading them with real money; it takes practice looking at charts to understand the intricacies and differences of these patterns and to know that a dead-cat bounce is real.

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