Lesson in Trading the Intraday Dead Cat Bounce April 7

Apr 7, 2011: 6:48 PM CST

I’m overdue for an intraday trading lesson!

Today gave us a great example of how to set-up, forecast, and trade a classic “Dead Cat Bounce” set-up on the intraday charts from a surprise or ‘shock’ move that created a large impulse move.

Let’s take a moment and learn this lesson step-by-step, keeping in mind that while I’m showing this concept on the 1-min intraday chart, this concept of “Impulse, Retracement into Resistance, and Sell-off Phase” is applicable to all markets and timeframes.

Here’s what it looked like at the time of trigger:

Let me do a quick review of the Dead Cat Bounce situation/set-up.

First, we can’t predict big breakout or sudden impulse moves in the market, but when they happen, we can anticipate a possible outcome that takes the form of a Flag or strangely named “Dead Cat Bounce,” giving us a small window of predictability which sets up a unique trade.

In English, the initial down-move in the stock market today occurred because of news of another earthquake in Japan, sending traders/investors on a “Sell First, Ask Questions Later” mentality.

Whatever creates the big impulse is not as relevant as how you recognize the pattern on the chart and prepare to trade the second movement down after an initial reaction up.

Translation – sudden, impulsive moves tend to create a rally up into resistance as traders get their bearings straight.  If on this rally, internals, volume, or momentum weaken considerably (form divergences), you can get ready to put on a “Dead Cat Bounce” trade which attempts to profit from the SECOND down-move after an initial reaction up.

It’s easier to see it in the chart than it is for me to describe it.

We’re looking at the @ES futures on the 1-min this morning after the initial plunge down and we saw a ‘retracement’ or ‘reaction’ up into resistance via falling moving averages (20 and 50 EMAs) and a standard Fibonacci Retracement grid.

An aggressive trader, thinking a new leg down was likely to come when this initial retracement ended, would look to put on a position INTO a resistance area, namely the 50 EMA (blue) with reversal candles just before 10:00am CST or on the final push to the 61.8% Fibonacci Retracement at 1,330 after 10:00am.

Either way, the trader would place a stop above the 61.8% Retracement and EMAs – either at 1,331, 1,332, or 1,333 depending on risk tolerance.

Ok, so that takes care of the aggressive entry (INTO resistance AHEAD of an expected turn-down in price) so the conservative “prove it to me” entry comes later on an actual/triggered price breakdown of the rising trendline at 1,329.

Either way, the minimum target is a retest of the prior low or even a target beyond that – which in this case would be the 1,324 level.

There’s your ‘real time’ step-inside analysis above of the potential down-move yet to come via a Dead Cat Bounce set-up intraday.

Here’s what actually happened:

Above, I show the four potential entries into this set-up, depending on your aggression level.

There’s two aggressive entries (INTO resistance) and two conservative entries (AFTER a trendline break).

I’m not here to tell you which is better – it’s up to you and your experience to determine that.

Anyway, the price did fall as anticipated and as forecast by the impulse move.

In my new Complete Trading Course book, I describe the “Momentum” principle (“Momentum Leads Price” in that new price and new momentum lows tend to forecast future tradable new price lows) in Chapter 2 and tie that together into the fun “Impulse Sell and Impulse Buy” retracement set-up in Chapters 9 and 10.

Price hit the initial ‘retest’ target just under 1,324, we had a positive momentum divergence and price reversed course to the upside – not really pushing to a new significant low (just a retest only).

A trader would cover the short at the 1,324 region either on the official test or on the actual price rally up after the reversal candles and momentum divergence.

Before you scoff, keep in mind that this trade profited 5 to 6 @ES points (about 50 cents in the SPY) which is $250 to $300 per contract (most traders trade more than 1) for a single trade that lasted 30 to 45 minutes.

If you’re not an intraday scalper, keep in mind that this “Flag” and “Dead Cat Bounce” concept – tied into the “Momentum Principle,” is applicable to all timeframes and markets.

I show similar “step-inside” educational analysis in each day’s “member Report” just like this, with the focus being on building your awareness and knowledge of both price principles and trade set-ups (management from entries to exit) so you’ll increase your confidence to locate and trade these set-ups in real time in future sessions.

In sum, no trade is 100% guaranteed to work, but the Dead Cat Bounce impulse set-up (composed of a big initial impulse, a reaction/retracement up, and the final downward impulse you can trade) is a good concept to learn and add to your developing trading arsenal.

A bigger example of this concept occurred on the daily stock market charts just after the “shocking” May Flash Crash – impulse up into resistance… which led then to a big swing down to new index lows.

But that’s another lesson!

Corey Rosenbloom, CMT
Afraid to Trade.com

Follow Corey on Twitter:  http://twitter.com/afraidtotrade

Corey’s new book The Complete Trading Course (Wiley Finance) is now available!

3 Comments

3 Responses to “Lesson in Trading the Intraday Dead Cat Bounce April 7”

  1. marketsniper Says:

    Outstanding, Corey! Played it like a violin today. Even caught the first move as methodology triggered a sell at 1332.25.

  2. sandew Says:

    @ Corey,

    I remember you started with 1Min. charts, then later resolved never ever to trade the 1Min. chart; so is it not futile to exhibit 1Min. chart to put across a lesson which in real time never delivers, rather the noise leaves one hopelessly frustrated. So, do please post charts of time frame which you trade and consistently gives more money to you.
    Thank You

  3. Corey Rosenbloom, CMT Says:

    While I started as your typical investor, I got into the day trading realm back in 2003/2004 and for my inexperience, the 1-min chart did not work for me at that time (didn't have a great understanding of what I was supposed to do then) so I went mostly to swing trading from 2005-2007 wherein after going full time in 2006, it was more practical/profitable to return to the intraday/day trading tactics, only now I had more experience in trading in general. From 2008 to present, I've focused mainly on intraday trading of the @ES while still doing swing trading mainly of ETFs. My active trading revolves around creating a narrative on the higher timeframes and then playing it out via the 5 and 1 min (5 for set-ups, 1 for execution/triggers).

    The main idea above is that the lesson in dead cat bounces is fractal and applicable to any timeframe, as was the case in the May 2010 flash crash period. I'm not saying a brand new trader should rush out to the 1-min chart, but for those who have experience and quick reflexes, the 1-min offers opportunities and clarity of entries/execution based on higher timeframe set-ups.

    As a new trader, don't start with the 1-min chart but as you gain experience/discipline/strategy/understanding of these concepts, you can decide if the 1-min chart is a possible source of deploying those strategies that suit your risk tolerance.