What is a bull trap & how to avoid it? — A complete guide

A bull trap is a situation where traders assume the price of a financial instrument will move upward due to false signals. It could occur in any financial market, including stocks, forex, indices, and commodities.

This trap could occur when the price breaks out a dedicated resistance level. It lures buyers to buy the instrument at the breakout, where they predict the price will rise.

Instead, it reverses back to the downside shortly afterwards, trapping these buyers and forcing them to close their position and deal with any losses they might’ve obtained.

A bull trap could occur in different market conditions, one of which is a bear market (downtrend market). 

When the price starts to rise, buyers could see this as a potential end to the downtrend, especially when using a resistance level and the price breaks out of that level, as mentioned above, to increase confidence in their prediction.

They would come in and open long (buy) positions. However, this is short-lived, and the sellers would soon come in and overwhelm these buyers, pushing the price lower and so continuing the downtrend.

Another market condition where a bull trap could occur is in a sideways, ranging, or consolidating market.

As the price of an instrument moves between the support and resistance level in a sideways market, the price may move higher, breaking out above the resistance level.

However, if there aren’t enough buyers to take charge of the breakout, the price could fall back into the range, trapping the traders who opened long (buy) positions at the breakout.

Lastly, a bull trap could occur when the market is coming to an end of an uptrend. As the price gets to a certain point and sellers start overwhelming the buyers, the price could give one more push before it sharply reverses, trapping those buyers who still had their long (buy) positions open.

A bull trap generally develops when the market has experienced a significant downtrend for some time and starts moving in the opposite direction; however, due to a lack of buying volume, the price begins rallying back down.

Once the market starts moving upwards towards a dedicated resistance level and breaks out of that level, the buying volume isn’t sufficient to sustain the upward movement. Sellers overwhelm the buyers, seeing the price move back past the resistance level and continue the downtrend.

The rallying of price back towards the downtrend traps those traders who opened long (buy) positions during the breakout above the resistance level, leaving them to deal with any losses.

Other fundamental analysis factors, such as any significant news events, geopolitical events, and company press events, could also cause bull traps.

Let’s take GBP/USD as an example; after a strong uptrend, GBP/USD starts moving downward, making a series of lower lows and lower highs.

The price soon starts consolidating after the downtrend, creating a resistance level where the price bounces off twice. It moves back up towards the resistance level a third time but then breaks out. However, this is a trap, and the price sharply reverses back down soon afterwards and continues with the previous downtrend. 

It trapped all those traders who opened a long (buy) position at the breakout, which resulted in losses. This is because the buying volume wasn’t strong enough to push the price higher, resulting in more sellers coming in, which pushed the price lower.

It might be essential to consider looking at multiple confirmation signals before considering opening a position; for example, a trader could use a technical analysis indicator such as the RSI (Relative Strength Index), where the instrument’s price is moving higher. Still, the RSI is moving lower, creating a bearish divergence, which could indicate that a bull trap is about to occur.

Another factor that might be essential is using a proper risk management strategy, such as placing a stop-loss order or a trailing stop order when a bull trap does occur to protect against any substantial losses.

Identifying when a potential bull trap is about to occur might be challenging. However, there are some techniques that might assist you in spotting a possible bull trap.

Below is a detailed breakdown of each of these techniques.

Resistance level being tested multiple times

A resistance level being tested multiple times could assist in spotting a possible bull trap.

After the market has experienced a strong and sustained bullish trend, it could move into a phase of consolidation, also known as a ranging market, where the price moves between levels of support and resistance. Both levels could be tested multiple times, attempting to break out.

A sharp upward move with little to no bearish momentum indicates buyers are putting in all they have into the market. As they push the price to a specific resistance level, they tend to respect it, and the price pulls back instead of breaking out and going much higher.

As we see in the picture below, bulls dominated most of the trend until they started experiencing resistance from sellers. 

As the price approached the resistance level, it was rejected multiple times before the bull trap was set, resulting in a fake out and sharply reversed into a downtrend.

Exceptionally large bullish candlestick

This correlates with the section mentioned above. In the bull run’s final phase, it could happen that a large bullish candlestick pattern will appear, towering above most of the candles to its left before multiple bearish candles form afterwards, causing the market to fall.

Several factors could explain why this happens: 

• The first one is buyers coming in and opening long (buy) positions, believing the breakout has occurred and the price is likely to push higher.
• The second factor is that big institutions and hedge funds are pushing the price higher to lure in buyers in order to trap them.
• Lastly, the sellers allowed the buyers to temporarily take control of the market so that the sell limit orders placed by sellers above the resistance level could be triggered, increasing the selling pressure and pushing the price lower.

Relative Strength Index (RSI) bearish divergence

As previously mentioned, the RSI is a technical analysis indicator that traders could use to spot a potential bull trap. 

The RSI is generally used to indicate whether a financial instrument is seen as overbought or oversold; however, in the case of a possible bull trap, traders could look at the direction of the trend on the charts and compare it to the direction of the RSI.

When the price starts moving upward, creating a higher high on the charts, while the RSI starts moving downward, creating a lower high, this could indicate a bearish divergence, in which the price might reverse into a downtrend soon after creating a bull trap.

Lack of increased volume

When the price reaches the resistance level and a proper breakout into an uptrend takes place, buying volume will generally increase, as displayed on the technical volume indicator on the charts.

Suppose a breakout does occur with low buying volume. In that case, it generally indicates there isn’t much interest in the specific financial instrument at that current price, and that break out could be a bull trap as the price might not end up moving in an upward direction. Instead, it might rally back into a downtrend shortly afterwards.

It might be essential to trade potential reversals with caution. Often, new traders get caught in bull traps because they tend to be too aggressive.

They generally enter a position as soon as price action turns bullish rather than waiting for further confirmation from other factors, such as volume or different momentum indicators, to indicate a potential reversal is imminent.

You might miss out on catching the entire move by waiting for further confirmation. However, you could protect yourself from falling into a potential bull trap.

Once the reversal has been confirmed, you could still enter the position and potentially profit from the majority of the movement as the price moves upwards.

Once the trade has been entered, it might be important to monitor certain technical factors such as price action, trading volume, and technical indicators to try and identify whether the market is losing momentum, which could cause the price to reverse.

You could look out for specific candlestick patterns, such as a shooting star or inverted hammer where the price rises but then falls back down, and the close of the candle is near the candle’s open, indicating a small body with a long wick.

This might also indicate that sellers are starting to take control, which could give you a better understanding of when to possibly close your position.

As we saw in the previous section, opening a long (buy) position as soon as the price breaks out of a resistance level could be risky, as many of these breakouts could result in a bull trap due to low buying volume.

Once a trader gets caught in a bull trap and their position starts sustaining losses, they could struggle to keep their emotions in check, which could result in decision-making mistakes such as keeping their position open for too long with the hope the market will reverse again and start moving upwards.

With that said it might be best to look out for a possible bull trap if the price moves above a resistance level or when the price moves above a previous swing high while the market is in a downtrend.

When the price starts dropping below the resistance level or previous swing high, you could look to enter a short (sell) position because the move above the resistance level or the move above the previous swing high turned out to be a false signal.

You could also use additional technical indicators or candlestick patterns for further confirmation.

When the market starts moving against your position, you could place a stop-loss or trailing stop order to protect against any possible losses. To protect any potential profits, you could place a take-profit order.

We’ve seen that a bull trap is a trading pattern where traders believe the price of a financial instrument is likely to continue moving upward; however, since it’s a false signal, the market reverses into a downtrend shortly afterwards.

Bull traps could occur when the price breaks out of a resistance level; however, because of low buying volume, the price retraces back below the resistance level, trapping those traders who opened a long (buy) position at the breakout, leaving them to deal with any losses.

Now, a bull trap isn’t the only trap traders might want to look out for. There is also a bear trap, where a trader believes the price of an instrument is likely to continue moving downward; however, since it’s also a false signal, the market reverses into an uptrend.

Bear traps could occur when the price breaks out of a support level; however, due to a lack of selling volume, this is short-lived, and the price retraces back above the support level. This traps those traders who opened a short (sell) position at the breakout, leaving them to deal with any losses.