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Dead Cat Bounce Chart Pattern

Type: Continuation Pattern

Appearance: An shallow upward bounce and declining price immediately following a steep decline.

Typical Duration: 2-4 days for the initial decline. From a few days up to 3 weeks for the bounce high to be reached. A few days to a few weeks for the drop below initial decline low. Up to 3 months for the final decline to play out.

Description: We will describe the pattern in terms of a decline for simplicity's sake, but please bear in mind that in the forex there is no bias, and therefore chart patterns work equally well in both directions. The logic behind this pattern is fairly simple. There was an unexpected event that caught the market off guard, and resulted in a sudden sell-off of the base currency against the quote currency. Once the selling subsided, many market participants decided to take profit on their short positions, and some perhaps even entered long positions in the hope that the event that caused the sell-off would somehow be mitigated. This causes a bounce in price, but once shorter term players who took profit are all done, the buying dies down again and the sellers take over, causing yet another drop well beyond the previous low.

  • Initial decline normally 20% or more;
  • Second decline continues another 15% from the bottom of the initial decline;
  • Total decline between 30% and 40%;

It should be noted that the larger the initial decline, the larger the bounce, due to more market participants being caught short and getting squeezed out of their positions. The quicker the initial decline, the quicker the bounce too. The whole picture is reminiscent of a bouncing ball.

Strengths: The dead-cat bounce is one of the highest probability chart patterns you will come across, particularly if the initial decline is steep and deep. The probability of a false break-out below the initial decline's low, known as "throwback" is minimal.

Weaknesses: By the time the dead-cat bounce occurs, you've already missed the meat of the decline.

How to Trade it:

There are several ways to trade this pattern

Type 1:

  1. Wait for bounce to round over and then short-sell the pair.
  2. Price is expected to decline to at least the previous low made by the sharp initial decline. Partial profit can be taken here.
  3. In most cases, price will continue downward, approximately 15% beyond the initial decline's low. A significant support level in this approximate area is normally a good place to exit the entire short position.

Type 2:

  1. Wait for a breakout below the initial decline's low. A daily close below this level is normally considered a confirmation of breakout. Waiting for the breakout increases the success rate of the trade, but decreases the amount of gain if the trade reaches your target.
  2. Place take profit target near a significant support level found near the 15% decline point, as measured from the initial decline's low.

Both Types of trades have their advantages and disadvantages. Type 1 trades have a slightly lower success rate, but can have a much better reward:risk ratio, while Type 2 trades produce a slightly higher success rate at the cost of a lower reward:risk ratio. Taking both into account, Type 1 trades offer a better overall expectancy, but traders may choose Type 2 if using other confirmation factors which further improve the Type 2 probability or R:R ratio.

Even if you don't trade the dead-cat bounce, it is strongly recommended that you avoid all bullish formations for the next 6-12 months, as they normally either fizzle out or produce below-average gains, and in most cases pushing your expectancy into negative territory.

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