There’s no better time than the present to learn about the notorious bull trap and how to avoid falling into it. This knowledge will help you steer clear of catching a falling knife in the financial markets.
What is a Bull Trap?
A bull trap is a false signal that typically occurs in a bear market. It tricks traders into thinking that the price of an asset is done declining. Therefore, the trader thinks it’s a good time to place a buy order. However, when the price soon resumes its decline, these traders lose money.
Essentially, this type of trap denotes a reversal against a short-lived bullish trend. It forces buyers to quickly exit their position or continue suffering losses because they thought it was the right time to buy.
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How Does a Bull Trap Work?
Consider the chart above. After the first descent, the price maintains a horizontal direction until it breaks out. The bull rally is then supported by four consecutive green candles with higher highs.
To the inexperienced trader, this means that the market has finally recovered and is in the midst of a reversal, indicating a great time to buy.
But as you can see, the bulls quickly ran out of steam, and the price went further down. If you placed a buy order after the initial breakout, you would have recorded considerable losses. Then, you’d be forced to exit the position to avoid incurring even more losses.
Sellers can also become more aggressive with their selling, which further pushes the price down. Any buyers still left in the trap then bear the brunt of the negative market movement.
That’s just a general overview of how a bull trap works. In many cases, the signs are more subtle, and it takes a trained eye to spot a bull trap pattern and pull out before the market turns red again.
How to Identify a Bull Trap
Identifying a bull trap is never easy, but can be simple if you know what to look for. It’s all about learning to recognize a failed breakout and a looming reversal. Here are some of the most common signs that a bull trap pattern is developing:
The Market Tests the Resistance Level Multiple Times
While not always a 100% sure sign, a market testing resistance levels multiple times and failing to break out indicates weak bullish pressure. It can signify that even if a breakout occurs above the resistance, it is unlikely to sustain its momentum.
Let’s say the price starts to climb unhindered but is unable to climb past that resistance over several trading sessions. Instead, it drops again. This could mean that a bull trap is on the way. Of course, the breakout may be legit in some cases, but it’s usually better to wait and confirm the trend before opening a position.
Long Green Candle Just Before the Market Turns the Other Way
If you notice an unusually long green candlestick at the end of a bull rally in a bear market, it could mean that more buyers are joining the bandwagon. They likely believe that the breakout has solidified, and it’s safe to start buying again.
But then again, it could also mean that whales (big market players and institutional investors) are intentionally pumping up the price to attract unsuspecting buyers. When enough buyers have entered the market, they suddenly start dumping, leaving the buyers to pick up the resulting losses.
This is a common occurrence in small markets, such as cryptocurrencies, with many inexperienced trades.
The Chart Forms a Range
A range occurs when the price moves up and down within a defined support and resistance level. This usually means buyers and sellers are both fighting for market dominance, but neither side seems to find enough momentum to come out on top.
Buyers are actively defending the support level and trying to push the price up. On the other hand, sellers are actively defending the resistance level and trying to push the price down. Eventually, one side wins for a period of time.
Refer to the chart in the previous section. You’ll notice that a range forming just before the market went down. The market could have also swung in the other direction, but it remained firmly enmeshed in the bearish territory in the above case.
Is the Asset Overbought or Oversold?
If you don’t know how to recognize bull trap patterns yet, you can always look at the relative strength index (RSI) indicator to see if the security is currently overbought or oversold.
If the asset is considered overbought, it will likely perform a bearish reversal shortly after the breakout. However, if deemed oversold, the prevailing bullish trend following the breakout may continue, though it’s best to wait for confirmation of the trend before opening your long position.
Bull Trap Example
There are several ways a bull trap can occur, but they revolve around a false breakout. If you’ve been trading for some time now, no doubt you would have encountered a bear trap or perhaps even fallen victim to it.
Let’s look at a recent example. The chart below shows the E-Mini S&P 500 (Dec-20) futures.
You’ll notice that the price breaks upwards and creates a new range. If you took a long position when the price was on the rise, you might have been expecting the range to end with continued upward movement.
However, the market went in the other direction. Those with long positions became trapped in the bearish downturn and incurred heavy losses.
One of the worst things about a bull trap is that you won’t immediately recognize that you’re in it until the damage is done. In which case, the only thing you can do is offload your shares to avoid incurring further losses.
What Makes Bull Traps Happen?
Bull traps can happen for various reasons. Most commonly, they occur because investors believe a market downturn has ended. They are eager to load up on shares at a bargain as they expect the price to begin going up.
This initial buying action can push the price further upwards and above resistance levels on the chart, eventually attracting even more buyers. But then it turns out the “breakout” was a false signal. There isn’t enough buying pressure to sustain the upward trend, so everything comes crashing back down.
It is also possible that when the price crosses the resistance levels, investors who are already holding long positions may decide to cash out and close their positions. That’s because they are happy with the gains they already made. This increases the supply of the asset and creates selling pressure in the market.
As the selling pressure continues to mount, and the price drops lower, stop-loss orders can start to get triggered. This only adds more fuel to the downtrend. As a result, the market breaks below its support level and establishes a new low. This essentially forms a bearish trend reversal signal.
Bull traps can also happen when there is low liquidity in the market. If it’s not easy to enter or exit the market due to low liquidity, volatility becomes more severe. When this happens, even small buy orders can result in a large upward movement on the chart.
Inexperienced traders can take this to mean that the bullish reversal is in effect and join in, only to be trapped when sellers re-enter the market.
Can You Trade During a Bull Trap?
Most traders and investors are more concerned with getting out of a bull trap than settling in and executing more trades. But yes, it is indeed possible to trade during a bull trap, provided you know how to escape it first.
One of the best ways to escape a bull trap is to set up a trailing stop-loss order as you open your position. This will help protect you against incurring further losses if a bull trap happens to catch you. More importantly, a trailing stop order will help you lock in as much profit as possible before the losses start coming in.
Trading a Bull Trap
Based on the above sections, you’re probably already thinking that it’s best to simply not trade a bull trap at all.
Still, if you’re up for it and are looking to do more than cut your losses, here are some helpful tips to keep in mind:
Don’t Panic
Panicking will only cloud your judgment and cause you to make decisions based on emotional convictions. Instead, accept the losses as is and move on. This will allow you to approach the next trade with a clear head.
Open a Short Position
You can open a short position, but only after you’ve confirmed the current downtrend. If you had taken the time to confirm the previous trade trend, you probably wouldn’t have fallen into the bull trap in the first place. Once the market shifts direction and you have confirmed the trend, open a short position. This way, you can rake in some profit to offset the previously sustained losses.
Ideally, you should only do this in markets with high liquidity. Consider also doing this with investment vehicles that do not require you to take direct ownership after taking a position. You want to get in and get out quickly if the market shifts direction again.
Go Long on the Retests
If you’ve been monitoring the chart up till the time the bull trap springs, then you can simply wait until the price retests the resistance level again. Wait for a few candles to retest the resistance within the range, then place your stop-loss just below the support level before placing your buy order.
Risk of Trading a Bull Trap
If you’re going to trade a bull trap, then you must be prepared to accept the risks. For one, the market can always change direction again.
For instance, the bull trap could be brief, and the following trading sessions can experience the bulls coming back even stronger. This means you could have made more profit if you had simply not traded the trap at all.
Additionally, trend confirmation signals are never 100% accurate. Therefore, there will always be a degree of speculation on every trade. Every speculation carries risk.
How to Avoid the Trap
You can avoid bull traps by taking the time to confirm a breakout before opening your position. There are several technical indicators and pattern divergences that you can use. Of course, this means you might lose out on some profits since you won’t be entering the trade immediately after the breakout. However, this approach may be a lot better than falling into the trap and suffering heavy losses.
Another great strategy for avoiding bull traps is to look at the trading volume following a breakout. If the volume is low, chances are the market will eventually resume its bearish trend since there isn’t enough trading action to absorb the breakout.
Lastly, don’t enter a trade after a temporary but lengthy uptrend in a bear market. In a typical bear market, if the trend has been going up for a sustained period, following a breakout, it is more likely to go down than continue going up.
F.A.Q
There is no standard time frame for how long a bull trap will last. At any given time, countless factors influence market movements. Some of the considerations here include current overall market sentiment, the type of security being traded, and any sudden catastrophic events that can prolong a bear market.
For instance, consider investors caught in the bull trap just before the recent global health crisis. In March, the financial markets crashed, and many were in a bull trap for a few months.
Because it targets bullish investors or traders looking to maximize profit on a perceived breakout. Unfortunately, it’s until the trade is already losing that most traders realize that they shouldn’t have opened the position in the first place.
