decline that spawns the dead-cat bounce,averages 25%. After the event decline, prices bounce up, round over, and continue down another 15%, on average (measured from the event low to the ultimate low). Together, the two declines see prices move lower by an average of
37%.The Results Snapshot outlines several unusual findings. The first onereminds me of a bouncing ball: The larger the event decline, the larger the
bounce. When an event sends prices tumbling rapidly and severely, the153
154
Dead-Cat Bounce
bounce, while correspondingly higher, occurs quicker. Short duration bounces(to the recovery high, anyway) follow large event losses; smaller event lossesare more shallow and take longer to reach their bounce high.
TourWhat is a dead-cat bounce? The name comes from the behavior of a stock afteran unexpected negative event. Figure 10.1 shows a typical example of a deadcat bounce. In late September, the smart money started selling their holdings,driving down the price and pushing up the volume trend. Prices declined froma high of 427/i6 to 3513/i6 in just over a week. On October 9, a major brokeragehouse lowered its intermediate-term rating on the stock. Down it went. In2 days the stock dropped from a high of 37 /i6 to a low of 26, a decline ofover 30%.For the next week and a half, the stock recovered somewhat, rising to
3213/i6 and enticing novice investors to buy the stock. The stock moved lower,then climbed again to form a double top. This was the end of the good news.From the second peak, it was all downhill until mid-January, when the stockbottomed at 1813/is. From the high before the event began to the ultimate low,the stock plunged 50%! Welcome to the dead cat bounce.Andrew Corporation (Telecom. Equipment, NASDAQ, ANDW)
Table 10.1Identification Characteristics ofCharacteristic
Discussion
Price gap
The daily high is below the(breakaway) on the chart.
plunge
On the negative announcemusually between 20% and 3covering 2 or 3 days.
Bounce
Prices recover somewhat adecline is not over.
Decline
After the bounce finishes, ansedate but prices typically d
Identification Guidelines
Are there characteristics common to the dealists them. Consider Figure 10.2, a 47%, 1
early February at 281/2. It moved lower followlate April. Then, it curled around at a low
minor high at 217/8. Then the Food and Dru
rejected Cephalon's Myotrophin drug appStreet, the stock gapped down and traded aa massive 8.4 million shares, more than 15
Cephalon Inc. (Drug, NASDEvent High
Figure 10.1 Typical example of a dead-cat bounce. A major brokerage firm lowered its rating on the stock, sending it tumbling 50% in about 3% months. Thedead-cat bounce allowed astute investors to sell their holdings and minimize theirlosses before the decline resumed. The twin peaks in mid-October and earlyNovember are a double top signaling further declines.
Apr 97
Jun
Figure 10.2 A negative announcement trigbegan when prices gapped down, bounced u
156
Focus on Failures
Dead-Cat Bounce
days, the stock recovered a portion of its decline by gaining $2 a share (low tohigh). Then the remainder of the decline set in. As if rubbing salt in the wound,the stock moved down again in an almost straight-line fashion. From the recovery high of 13'/2 to the new low of 9l/2, the stock declined another 30%.Figure 10.3 shows an even more alarming decline. Just 3 days before themassive decline, a brokerage firm reported that it believed the company wouldcontinue seeing strong sales and earnings trends. Perhaps this boosted expectations, but when the company reported a quarterly loss—instead of the profitthe Street was expecting—the stock dropped almost 43 points in 1 day. That isa decline of 62 %.The stock gapped downward, a characteristic that most dead-cat bouncesshare. A negative news announcement is so surprising that sell orders overwhelmbuying demand. The stock declines and opens at a much lower price. Volumeshoots upward, typically several times the normal rate. Figure 10.3 shows that 49million shares exchanged hands on the news, about 20 times normal.Usually the 1 -day decline establishes a new low and prices begin recovering almost immediately. Figure 10.3 shows that the stock made a new low thefollowing day but then closed up a day later.After a massive decline, the bounce phase begins. Most of the time, astock will rise up and retrace some of its losses. However, the bounce phase forOxford Health Plans was brief—only 1 day. The stock closed higher, but thedownward trend resumed the next day. In less than 2 months, the stockdropped by half, from a high of 28% to a low of 133/4.
157
What types of events cause these massive declines? Almost all the events arecompany specific: negative earnings surprises, bad same-store sales numbers,failed mergers, accounting sleight of hand, outright fraud—that sort of thing.Sometimes the news affects more than one company. Figure 10.2 shows whathappened to Cephalon, but Chiron stock was not immune. Chiron has a jointdevelopment and marketing agreement with Cephalon for the Myotrophin drug,so its stock also took a hit, but not nearly as large (less than 5%) as Cephalon.Most of the time investors cannot predict the event. If you own the stock,you will lose your shirt. The question then becomes, how much of yourremaining wardrobe do you want to lose? We see in the Trading Tactics section that it pays to sell quickly.
Focus on FailuresNot all massive declines end in a dead-cat bounce. Consider the event shownin Figure 10.4. On April 3, 1997, die company released earnings that fell shortof expectations and announced that its merger with another company was terminated. Several brokerages downgraded the stock. It tumbled from a high of17'A to a low of 95/s, a decline of 44%. Like all dead-cat bounces, the stockrecovered. However, instead of bouncing up then turning down and movinglower, this stock continued trending up. In less than 3 months, the stock recovered its entire loss.
Oxford Health Plans (Medical Services, NASDAQ, OXHP)Checkpoint Systems (Precision Instrument, NYSE, CKP)
Oct97
Figure 10.3 Negative news announcement triggered the massive 1-day decline,which saw prices drop by 43 points or over 60%, but the decline was not over asthe stock fell an additional 43%.
Figure 10.4 A dead-cat bounce formation failure. After the decline, the stockmoved higher and kept rising instead of moving back down.
158
Statistics
Dead-Cat Bounce
159
Table 10.2 contains the general statistics for the dead-cat bounce. I located 244formations in 500 stocks over 5 years. Of these formations, 54% act as reversals of the prevailing trend, and the remainder act as consolidations. Almost allthe formations (90%) perform as expected. That is to say, after a major decline,the stock bounces and heads lower. Only 20 move lower without a significant
ultimate low. After the stock completes its major decline and bounces upward, therecovery low is the lowest price before any significant rise signals a trend change.The most likely decline is in the 30% to 40% range. This is unusual asmost formations have a few large declines that skew the overall averageupward. With the most likely decline near the average, the declines are wellspread as seen in Figure 10.5. Notice the bell-shaped graph. The graph showsthe results of a frequency distribution of losses from the high price the daybefore the decline to the recovery low.The average event loss is 25%. The event loss is the difference betweenthe high the day before the large decline to the lowest low before the bouncebegins, expressed as a percentage. A frequency distribution of the event lossshows that the most likely event loss is 20%.The event loss happens quickly, usually in just 2 days. This is the massivedecline that gets the ball rolling. Most times the stock suffers a large 1-day lossthen makes a lower low the next day before entering the bounce phase (a 2-daydecline occurs 71% of the time). Sometimes the stock will continue movingdown for a few days, but most (92%) begin rebounding in 4 days or less.Most market participants find the negative news surprising. As such, prices
bounce and 4 trend upward; they are the failures.The average decline, as measured from the high the day before the majordecline to the recovery low, is 37%. The recovery low is usually the same as the
gap lower (that is, the current day's high is below the prior day's low, leaving agap on the price chart). Only 22% of the formations showing a gap close them(prices rising far enough to fill the gap) during the bounce or recovery phase.
Why did the stock fail to bounce and head lower? Events that take place justafter the negative news announcement explain the stock's behavior. Several insiders bought the stock. Even the company got into the act and announced it waspurchasing 10% of the stock. Together, the news sent the stock moving higher.Subsequent events kept the momentum building and the stock continued rising.A survey of all 24 failures in the database reveals that 83% have stock
trends that continue moving lower without any significant upward bounce.The remainder (4 formations) are similar to that shown in Figure 10.4, that is,prices rebound and move up.
Statistics
Table 10.2General Statistics for the Dead-Cat BounceDescription
Statistic
Number of formations in 500 stocksfrom 1991 to 1996
244
Reversal or consolidation
113 consolidations, 131 reversals
Failure rate
24 or 10%
Average decline of successful formations(event high to recovery low)
37%, with most likely loss between30% and 40%
Average event decline
25%, with most likely loss 20%
Average event duration
2 days; 92% last 4 days or less
Number of formations with price gap
194 or 80%
Number of gaps closed during recovery
48 or 22%
Number of gaps closed in 3 months
80 or 36%
Number of gaps closed in 6 months
119 or 54%
Average recovery bounce height
19%
Additional postevent decline
15%, with most likely loss between5% and 25%
Average postevent duration
3 months (90 days)
Number of formations declining belowevent low
198 or 81%
Even in 3 months, only 36% close the gap and slightly over half (54%) closein less than 6 months. Since 80% of the formations show gaps and only half
50
t
Percentage Loss
Figure 10.5 Frequency distribution of total loss. Note the bell-shaped graph oftotal losses from the high the day before a large decline to the recovery low. Themost likely decline is 30% to 40%.
160
Dead-Cat Bounce
close within 6 months, the long-term bearish implication of this formationbecomes obvious.During the bounce phase of a dead-cat bounce, the stock rises 19%, onaverage (as measured from the event low to the recovery high). Does thebounce height relate to the severity of event loss? Yes. In simple terms, thelarger the event loss, the larger the bounce. Figure 10.6 shows the relationship.An additional 15% loss (as measured from the event low to the recoverylow) occurs after the recovery bounce completes and prices start decliningagain. Prices usually fall below the event low and continue moving down. Afrequency distribution of the postevent loss ranges from 5% to 25% and isevenly distributed. This wide range suggests that even though the eventdecline may be massive, sometimes substantial additional losses follow. Thepostevent loss occurs much more slowly, averaging about 3 months (90 days)in duration, as measured from the event low to the recovery low.Figure 10.7 shows the relationship between event loss and the number ofdays to the recovery high (the highest high reached during the bounce).Although it may be difficult to see the relationship, one can generally say thatas the size of the event loss grows, the days to the recovery high lessen. In otherwords, the bounce becomes steeper (occurring quicker). This seems to be contrary to what you would expect.Taken together, Figures 10.6 and 10.7 suggest that short duration, highrecoveries (to the recovery high, anyway) follow large event losses. Smallerlosses are more shallow and take longer to reach their bounce high.
Figure 10.6 Relationship between event loss and bounce height. Like a ball, thelarger the loss the larger the bounce.
Statistics
161
Figure 10.7 Relationship between the event loss and days to the bounce high.The line helps describe the relationship but has no statistical significance.
Over 8 out of 10 (81%) formations decline below the event low. Theevent low is the low price reached after the massive decline but before thebounce. This statistic emphasizes that even though you have suffered a painfulloss (or had your profits trimmed), you should still sell your position becausefurther losses are coming.Table 10.3 shows additional statistics related to the dead-cat bounce.Every formation showed extraordinarily high volume on the day the eventoccurred. After prices decline, they recover and reach a bounce high in lessthan 3 weeks (19 days).Where in the yearly price range does the event occur? A frequency distribution of the day before the event indicates that most stocks (40%) arewithin a third of their yearly high. The center third of the yearly price rangefollows closely with 39%. When you substitute the percentage loss into theyearly price range, you find returns behave about the same. The average formation declines between 35% and 37% regardless of where it begins in theyearly price range (as measured from the day before the event begins).Breakout volume is massive (596% of the prior day's volume) and continues to be high for the next week.I looked at gaps and tried to discover if they hold any special significance. Doformations with gaps have larger event losses? No, since the average decline is24% for those formations with gaps and 27% without. Do formations with gapshave a better recovery (that is, do they bounce higher)? Again, the answer is no asthe recovery rise is 18% for those formations with gaps versus 20% without.
162
Dead-Cat Bounce
Sample Trade
Table 10.3Additional Statistics Related to the Dead-Cat Bounce
163
I auie IU.H
Trading Tactics for the Dead-Cat Bounce
Description
Statistic
Trading Tactic
Explanation
High volume event (at least 50% above prior day)
238 or 1 00%
Wait for rise, then sell
For successful formations, days to recovery high(from event end)
1 9 days
The stock will make a new low then begin to bounce. Sellafter the bounce rounds over, usually in 1 to 2 weeks. Theworse the event decline, the quicker the bounce highappears, and the higher prices bounce.
Short sales
Sell short after the bounce rounds over. Expect a decline toat least the event low. Most of the time (81%), the stockcontinues lower by another 15%, on average.
596%, 304%, 1 77%,154%, 140%, 125%
Avoid formations
Percentage of formations with gaps having largerevent declines than formations without gaps
Avoid all bullish chart formations for at least 6 months (oreven up to a year) in a stock showing a dead-cat bounce. Ifthey work at all, the gains are below average.
24% versus 27%
Note: Wait for the bounce, then sell or sell short.
Percentage of formations with gaps having betterrecovery (a higher bounce) than formationswithout gaps
1 8% versus 20%
Sample Trade
Percentage of dead-cat bounces occurring near the1 2-month low (L), center (C), or high (H)
L20%, C39%, H40%
Percentage loss for each 1 2-month lookback period
L37%, C35%, H37%
Volume for breakout day and next 5 days comparedwith day before breakout
Note: The negative event occurs on high volume, the bounce occurs quickly, and therecovery is slow.
Once satisfied that you know the implications of the bad news and the reasonsfor the stock's massive decline, short the stock. Consider Figure 10.9, a deadcat bounce in Cerner Corporation. The stock dropped five points (25%) afterthe company said earnings would fall short of expectations and the outlook for
Trading TacticsThere is not much that can be said for trading the dead-cat bounce unless youare shorting the stock (see Table 10.4). For long positions, wait for the bouncethen sell. About a third of the time (36%), prices reach the bounce high in the
first week. Over half the formations (56%) take 2 weeks or less. When thestock peaks and rounds over, dump it. If you choose to hang onto your position, you will likely incur further losses and it may take well over 6 months
before you come close to recovering them. Why not invest your remainingcapital in a more promising situation?If you are considering selling the stock short to profit from the impend-
ing decline, look at Figure 10.8, which shows the percentage decline from thebounce high to the recovery low. On average, the most likely decline isbetween 15% and 25%, large enough to risk a trade.The last trading tactic is to be aware of the dead-cat bounce and its effecton prices. When a severe decline takes hold of a stock, the cause is not trivial.It takes time for the company to fix the problem and recover. Ignore any bull-
ish chart formation occurring in a stock in less than 6 months (even up to ayear). The chart pattern will likely fail or, if it works, the rise may be shortlived when the company announces more bad news (such as poor quarterlyearnings).
Figure 10.8 Frequency distribution of declines from the bounce high to therecovery low. If you time your short sale correctly, the profits can be rewarding.
164
Dead-Cat Bounce
11Diamond Topsand Bottoms
]un96
Aug
Sep
Figure 10.9 A negative earnings announcement triggers a dead-cat bounce. Jillsold the stock short just after the bounce high then covered when prices closedabove the trendline. The trade resulted in a 20% gain in 1 month.
R E S U L T S SNAPSHOTDiamond Tops
the remainder of the year was grim. The stock closed higher on each of thenext 4 days then closed lower. Jill, after seeing the stock climb the hill, sold thestock short and received a fill at the closing price of 15. She then waited, watching the stock closely. It continued moving down—as predicted.The earnings announcement forced the stock down another 20% in 2days. Expecting another dead-cat bounce, Jill held on to her position. Thestock rose in an uneven fashion over then next week or so, then rounded overand headed lower.Jill connected the tops from the preannouncement day onward in a downsloping trendline. When prices eventually closed above the trendline, she knewit was time to close out the position. The next day she bought the stock backand received a fill at 12, 1A below the daily close. She sat back and totaled upher profits and realized she made almost $3 a share, or about 20% in just1 month.As good as the trade was, had she waited until November to close out theposition, she would have made an additional $1.50 a share (the stock reached alow of 10'/2). However, between the time of covering the short and the ultimatelow, the stock climbed back to 171A. The moral is, you never go broke takinga profit.
Appearance
Diamond pattern forms after an upward price trend.
Reversal or consolidation
Short-term (up to 3 months) bearish reversal
Failure rate
25%
Average decline
21%, with most likely decline being 20%
Volume trend
Downward until breakout
Fullbacks
59%
Percentage meetingpredicted price target
79%
See also
Head-and-Shoulders Tops
Diamond BottomsAppearance
Diamond pattern forms after a downward price trend.
Reversal or consolidation
Short- to intermediate-term (up to 6 months) bullishreversal
Failure rate
13%
Average rise
35%, with most likely rise being 15%
Average volume trend
Downward until breakout165
166
Diamond Tops and Bottoms
Tour
167
Throwbacks
43%
Tour
Percentage meetingpredicted price target
95%
See also
Head-and-Shoulders Bottoms
What does a diamond top or bottom look like? Figure 11.1 shows a goodexample of a diamond top. After rising steadily since mid-February, the stockjumps 1 1 /2 points on April 20. Volume on that day is well above average. Then,the stock forms higher highs and lower lows, as if it is tracing a broadening toppattern. Volume diminishes throughout the early pattern development. Then,things reverse. The third minor high calls the top and prices decline. Theminor lows begin moving higher even as the tops are descending. This phaseof die pattern looks like a symmetrical triangle. However, volume continuesreceding, albeit at an irregular rate.Prices break down out of the pattern on June 8 accompanied by volumethat is about average. Prices meander sideways for about 2 weeks before plunging and retracing all the gains since the mid-April, 1-day rise.The pattern is a diamond top; it signals a reversal of the prevailing pricetrend. The chart in Figure 11.1 shows the typical behavior of a top: Pricesreturn to the level before the diamond begins. In this regard, the reversalstands out like a sore thumb. Of course, not all tops act this way. Some signala reversal of the primary trend and prices not only retrace their recent gainsbut continue moving down.The diamond bottom, shown in Figure 11.2, is similar to the top versionwith the exception of the prevailing price trend. In Figure 11.2, prices aretrending down toward the diamond bottom. In Figure 11.1, prices are trending upward before the start of the formation.
The Results Snapshot shows the important results of diamond tops and bottoms. In appearance, the only difference between the two diamond patterns isthe price trend leading to the formation. For diamond tops, the prior pricetrend is upward, whereas diamond bottoms have price trends that lead down tothe formation.The performance of the two types is similar. Both act as reversals of dieprevailing price trend with a volume trend that diminishes over time. Volumeon the day of the breakout is also high.The failure rate for tops, at 25%, is more than double the rate for bottoms. I consider failure rates above 20% to be alarming, so you might considertops unreliable.The average decline (21%) and rise (35%) is about what you would expectfor reversals, with bottoms a bit shy of die usual 40% rise for bullish formations. However, the most likely decline for tops is near the average, suggestingthat there are few large declines to distort the average. Diamond bottoms, witha likely rise of just 15%, are well away from the 35% average gain. This suggests there are a high number of formations with smaller gains that balance afew larger ones.Baker Hughes (Oilfield Svcs./Equipment, NYSE, BHI)
Coors, Adolph Co. (Beverage (Alcoholic), NASDAQ, ACCOB)
-24
-25-24-23
17Feb 95
Mar
Figure 11.1 A good example of a diamond top. Notice that prices quickly returnto the $20 level.
]u!91
Figure 11.2 A diamond bottom reversal. Volume typically recedes through theformation until the breakout day.
168
Diamond Tops and Bottoms
The diamond bottom begins by widening out and tracing higher highsand lower lows, then the process reverses. The price range narrows until thebreakout occurs.
Asarco Inc. (Copper, N
Volume throughout the formation is diminishing. The breakout usually
sports a significant rise in volume. Figure 11.2 shows high volume on thebreakout when prices gap through the diamond boundary. In less than 3months, the stock climbs over 20% to a high of 22'/4.
Identification GuidelinesTable 11.1 lists the identification guidelines for diamond tops and bottoms.Consider the diamond top pictured in Figure 11.3. The short-term price trendis up just before the formation, leading to the minor high on the left. Thenprices decline and form a minor low before moving higher again. In late September, prices reach a new high before cascading downward to finish below theprior minor low. Again, prices rise up and form another minor high beforebreaking down through the upward trendline on the right. The fluctuations of
minor highs and lows form a diamond shape when the peaks and valleys connect such as that shown in Figure 11.3. Notice that the diamond is not symmetrical; irregular diamond shapes are common for diamonds.
Table 11.1Identification Characteristics of Diamond Tops and BottomsCharacteristic
Discussion
Prior price trend
For diamond tops, prices usually trend up to theformation, whereas bottoms usually form at the end ofa downward price trend. With this definition, diamondtops (or bottoms) need not form at the top (orbottom) of a price chart—they can form anywhere.
Diamond shape
Prices form higher highs and lower lows (wideningappearance), then lower highs and higher lows(narrowing appearance). Trendlines surrounding theminor highs and lows resemble a diamond. Thediamond need not appear symmetrical.
Volume trend
Diminishing over the length of the formation
Breakout volume
Usually high and it can continue high for several days
Support and resistance (SAR)
The formation creates a location for support orresistance. Diamond tops usually show SAR near thetop of the formation, whereas diamond bottoms showSAR near the formation bottom. SAR duration can lastup to a year or more.
Oct
Figure 11.3 A diamond top masking a headthe bearish outlook is certain.
The volume trend is receding, especiallywhen the price range is narrowing (and the crical triangle). The breakout volume is usuala properly behaved diamond. In Figure 11.3and succeeding days is tepid at best but trend
The pattern is a head-and-shoulders topright shoulder marked on Figure 11.3. Thehead-and-shoulders top, with the right showhen compared to the left shoulder or headShould you locate a diamond pattern aand-shoulders top, do not worry. In both case
such a collision occurs, choose the formatiovative performance results (see the measure
Support and resistance for diamond top
the formation, as seen in Figure 11.4. The di
level, repelling prices during the rise in M
pierced until a year later.Acongestion zone forms in October 19following year before prices climb convincingthen, during April and May 1994, prices arecreated a year and a half earlier.
Figure 11.5 shows a diamond bottom.
nearly 2 months, leading to the formation.
170
Diamond Tops and Bottoms
«tw^ enterprises (Manuf. Houslng/Rec. Veh., NYSE, FLE)
|,t'1'-'
Gillette Co. (Toiletries/Cosmetics, NYSE, C)
Figure 11.5 A diamond bottom with receding volume trend. Prices quicklyrecover and reach new highs.Figure 1 1 .4 Support and resistance for diamond top appears at top of formation.A support and resistance zone at 31 created by the diamond top lasts for a yearand a half. Note the weekly time scale.
Teradyne Inc. (Semiconductor Cap Equip., NYSE, TER)
range widens as higher highs and lower lows appear. Then the tide turns andthe range narrows; higher lows follow lower highs. The diamond pattern takes
shape after connecting the boundaries of the price movements.Trading volume throughout the formation is receding. This is typical butnot a prerequisite for a well-formed diamond bottom. As in diamond tops,
there are wide variations in the volume pattern. Overall, however, the volumetrend diminishes over time until the breakout, then volume usually jumps
upward. Figure 11.5 shows that breakout volume is four times the prior day butis just slightly above average for the stock.Figure 11.6 illustrates the support area often promoted by diamond bottoms. The figure shows support at the $10 level on a weekly scale. Althoughsupport varies from diamond to diamond, when it appears after a diamond bottom, it is usually near the base of the formation. Another area of support com-
monly appears when the stock throws back to the level of the breakout. Figure11.6 shows an example of this. After climbing away from the formation afterthe breakout, a stock sometimes pauses, reverses course, and heads lower. Support meets prices that decline into the formation area, usually stopping brieflynear the breakout price, then prices turn around again and head back up. This
93
M
A
M
I
A
S
Figure 11.6 Support areas for diamond bottoms are near the base of the formation. Shown here is support at 10 on a weekly scale.
throwback to the formation happens more than a third of the time (43 %) and
represents another opportunity to initiate a trade or add to a position.
171
172
Diamond Tops and Bottoms
Focus on Failures
Focus on FailuresNot all diamond tops and bottoms work out as expected. Figure 11.7 shows adiamond top that fails to breakout downward. As in Figure 11.1,1 would expectthe stock to return to its jump-off point, that is, the 108 level. Instead, the stockbreaks out upward and continues moving higher until it reaches a high of1273/4. The move, which occurs less than 2 weeks after the breakout, signals a
173
downward. The lesson is that you should wait for the breakout before tradingyour position.Figure 11.8 is an example of a failed diamond bottom. The stock reachesa high in early February at a price of 32'/4, then heads lower. The diamondforms at about the level where the prior downtrend stops descending (in earlyApril). One could expect the stock to stop falling when it meets support. For
stock touches bottom at 92'/2, well below the breakout price of 1183/8. If you
almost 2 months (April and May), that is exactly what happens. The stockmoves horizontally, forms the diamond bottom, but then breaks out downward. Briefly, the stock pulls back