The "Dead Cat Bounce" Theory

Over the years, traders have been searching for consistent behavior in stock prices.
One of the theories is the "Dead Cat Bounce" syndrome.

My take on the "DCB" goes like this: If a stock goes down drastically (10-20%), over a short period of time (1-3 days), with extremely heavy volume (300%+ the average daily volume); chances are that within the mext 6 months or so, the stock price may bounce back to retrace to a level halfway up the gap... That did not sound right. Did it?

For example: a stock closes on a given day at 40.00 with an average daily volume of 500 thousand shares/day. Next trading day, it goes down to 34.00 (off 6.00 or -15%) with a volume of 2 million shares on bad news (such as disappointing earnings); it is possible that, in the mext 3-6 months, the price could fill the gap to its halfway point (approx. 37.00).

Now, this is only a theory and a very risky way to invest. The risk to reward ratio are somewhat commensurate.

The bad news that drive the stock price down cannot be so negative that would have a long term effect on the stock valuation. In fact, it could become a bargain if there is an over-reaction by the sellers and the news are viewed as short term.

Having followed this theory over a period of several years, I have gone one step further and "honed out" this approach. The parameters are: two gaps down (10% or more each) within a period of four months, on heavy volume (3x the average daily volume), then consider buying the stock within one week after the second drop. The company should show consistent earnings and trade a minimum of 300 thousand shares on the average.

Two examples are: CSCO and SMCI (take a look at the one year chart)

It is good to remember that most of the capital at risk could very well disappear on additional bad news or a market downturn.
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