A bull trap is a false signal, referring to a declining trend in a stock, index, or other security that reverses after a convincing rally and breaks a prior support level. In trading, a bull trap is a situation where a trader buys an asset believing its price will continue to rise, only to see it fall sharply after reaching a new high.
It is noted that bull traps occur during periods of market uncertainty or when false information is circulating about a particular asset. It's called a bull "trap" because traders who are none the wiser are made to believe that a declining asset is actually on the rise. This false sense of security can lead to heavy losses.
When a bull trap is suspected, traders should exit the trade immediately or enter into a short position. Stop-loss orders can come in handy in these scenarios, especially if the market is moving swiftly, to avoid being swept away by emotions. As with a lot of things in trading, identifying a bull trap can be difficult. However, the best way to avoid bull traps is to notice warning signs in advance—such as low volume breakouts.
From a psychological point of view, bull traps occur when bulls fail to support a rally above a breakout level, which could be due to a lack of momentum and/or profit-taking. Bears may jump on the opportunity to sell the security if they see divergences, dropping prices below resistance levels, which can then trigger stop-loss orders.
The best way to handle bull traps is to recognize warning signs ahead of time, such as low volume breakouts, and exit the trade as quickly as possible if a bull trap is suspected. Stop-loss orders can be helpful in these circumstances, especially if the market is moving quickly, to avoid letting emotion drive decision-making.
How To Identify A Bull Trap
It’s hard to identify a bull trap because normally after a breakout, an asset would be likely to increase in price, not reverse. What you can do is carry out technical analysis and fundamental analysis on the asset you want to trade. Look for whether the asset is currently overbought, which could indicate a bearish reversal from the prevailing bullish trend. You could also wait before opening long position following a breakout, to see if the bullish trend continues.
How To Escape A Bull Trap
The best way to escape a bull trap is set a stop-loss on your position as you open it. This will help you to prevent heavy losses if you’re caught out by a bull trap. There are a few kinds of stop-losses to choose from, including standard, trailing or guaranteed. When trying to avoid a bull trap, a trailing stop would probably help you the most, because it will trail behind the current market value by a set amount of points, and it will automatically close your position if the market value falls by that set amount. This will help you to lock in as much profit as possible, while also cutting losses early on into a bull trap.
What Does A Bull Trap Mean In The Crypto Market
Also referred to as "dead cat bounce," bull traps are often seen in crypto due to speedy recoveries. In crypto, bull traps work as they do in any other market. For instance, if the price of an altcoin has been rising steadily over the past few days, you may believe it will continue to rise. You buy some and wait for the price to go up so you can sell it at a profit. The opposite happens, and you find yourself trapped in a losing position. You witness the downtrend and then wait for a bullish reversal when you can buy the dip, thinking you're purchasing the asset at a good price. The trap reveals itself as such when the price retreats and goes back on the downtrend.
What Are Bull Traps Used For
Bull traps are used by both day traders and long-term investors to take advantage of unsuspecting market participants. For day traders, a bull trap can be an opportunity to short the security as it rallies back up to the previous high. The price will then resume its downtrend, leading to profits for the trader. For long-term investors, a bull trap can be an opportunity to buy the security at a lower price as it falls back down after the rally. They are then able to hold the security for the next uptrend.
Conclusion
You can trade a bull trap by opening a short position when you identify that a bear trap is in effect. You can go short with financial derivatives like CFDs. These enable you to take a position on an asset without having to directly own it, making them well-suited to shorting.
Thus, new bulls get trapped in long trades and incur rapid losses, unless aggressive risk management techniques are undertaken. The trader or investor could have avoided the bull trap by waiting for a breakout to unfold before purchasing the security, or at least mitigated losses by setting a tight stop-loss order just below the breakout level.
Source: Cointelegraph | Investopedia | IG