A dead cat bounce is a trading term used to define when a stock in a severe decline has a sharp bounce off the lows. A dead cat bounce occurs due to the enormous amount of short interest in the market. Once the supply and demand is unbalanced, any sort of bear market rally will generate a massive short covering which leads to a swift price move up. This bounce is short lived and followed by heavy selling which breaks the preceding price low. A trader can use a bottom-up approach when selecting the best candidate for taking a long position, because the investor should be very intimate with the company’s financials and management team.

The dead cat bounce phrase has its origin in the East. The first mention of the phrase occurs in 1985 when after the Singaporean and Malaysian markets bounced after a strong bear market decline. A journalist Chirstopher Sherwell of the Financial Times reported that a stock broker referred to the rally as a “dead cat bounce”.

Trading a dead cat bounce is only for seasoned traders. The first challenge is that the stock is often a falling knife, so deciding where to pick up some shares is somewhat of a gamble. The best method is to wait for an explosive move in volume, followed by a candlestick reversal pattern. After taking the long position, do not get greedy. Look to sell out on the first sign of weakness as the up move will be short lived.

Below is a charting example of Fannie Mae from late 2007 through mid-2008. Notice how there was a dead cat bounce up to $35, before the sharp sell off below $10.