How often have you encountered a situation where you bought (or sold) a breakout, but then the market turned on a dime, causing you to doubt yourself and question whether or not you had entered the market at the wrong time? These setups are often referred to as induced buying or selling. What if you could potentially identify these traps before they pan out?
Among those market traps, bull and bear traps are commonly known for their repeated appearance in markets. A bull trap happens when you go long only to have the price reverse and move dramatically downward. A bear trap is the opposite, where you go short only for the price to shoot higher, leaving you offside and out of pocket.
Bull traps often occur around prior highs when the price seems to go through the level. Amateur traders tend to enter too early at such critical levels. When the price reverses, they keep their positions open for too long and may even add to their current position in hope. As the price moves against them, the loss becomes larger. The trapped traders are then forced to close their position, accelerating the reversal even further.
In this article, we'll discuss how to spot bull traps and what preventive measures you can take to avoid them or even use them in your favour.
In this article
A bull trap can be interpreted as a false break above a resistance level. These setups may deceive optimistic traders into going long on the assumption that an upward price movement is just getting started.
Buyers falling into the bull trap will soon find themselves offside when the price reverses and continues its downward movement. Buyers who fail to see the bull trap and do not close their position quickly will incur losses as the price falls.
A bull trap generally develops after a sustained bull run.
Usually, buyers will have been in charge for a long time but then start to take their profits as prices approach a resistance zone. As shorter candlesticks appear, this is a sign that the bullish momentum is slowing down.
Following this, the market consolidates before additional buyers enter and attempt to push the price over the resistance zone. Some buyers see this as a continuation of the upswing (a breakout to the upside) and buy the market.
However, sellers start placing sell orders, hoping that the resistance level will hold since most bullish momentum has been depleted. Smart and experienced traders who understand this phenomenon begin to close their long positions.
As a result of fleeing buyers and aggressive sellers, the momentum shifts in favour of the sellers. As the price falls lower, the new buyers' stop losses are executed, strengthening the selling pressure.
Buyers who anticipated that the trend would continue to rise had set their stop losses. Those with wide stops or no stops are trapped in a trend that has turned against them.
Identifying a bull trap can be straightforward if you understand what to look for. The following are some techniques indicating that a bull trap is on its way:
The first indication of a possible bull trap is where a strong and sustained bullish trend is rejected as it attempts to break above resistance.
A sharp upward move with little to no bearish momentum indicates buyers are putting all they have into the market. When they push the price to a specific resistance level, they tend to respect it, and the price pulls back before going much higher.
The chart below shows that the bulls dominated the price movement for most of the trend.
However, whenever the price approached the resistance level, it would slow down and pull back somewhat before resuming its upward trend. As we can see, there were multiple tests of resistance before the bull trap was set up. When this happens, you should patiently wait for the market to break out, flip this resistance into support, and then buy.
In the bull run's final phase, it can happen that massive bullish candle towers above most of the earlier candlesticks to the left.
There are several plausible explanations:
One, fresh buying is seen in anticipation of a breakout.
Two, large institutional players may purposely boost the market to get a more favourable selling price.
Three, the sellers have cleverly allowed the buyers to temporarily take control of the market so that sell limit orders above the resistance zone may be triggered.
Another indication of a bull trap setup is forming a range below a resistance level. A range indicates that prices are consolidating before a breakout or a reversal. So it would be best if you always waited for confirmation to see whether the price breaks out of the range to the upside or reverses from the resistance zone.
The most reliable way to avoid falling into a bull trap is to be careful while trading potential reversals. New traders often get caught in bull traps because they are too aggressive. They enter a position after interpreting that the price action remains positive rather than waiting for a confirmation to indicate a reversal.
By waiting, you may not catch all of the move, but you also significantly minimise your chances of slipping into a bull trap and losing money. Once a reversal is confirmed, you may still enter a trade and benefit from the downward price movement.
After entering a trade, monitoring price action, trading volume, and technical indicators is critical. You can also use candlestick patterns to help you interpret the price action. For example, inverted hammer and shooting star candlesticks might suggest that bears are regaining power.
Finally, bull traps often result in strong and prolonged price swings and trend reversals. Keeping a close eye out for a possible trend reversal will help you trade bull traps more successfully.
Before placing a sell order, wait for a break below an important support level or the creation of a new lower low. Although this may mean leaving some profits on the table, you will have a better chance of being on the right side of the market.
The bull trap teaches us that buying at the very start of a breakout might be risky. Many of these attempted upward moves may fail due to a lack of additional buying pressure.
Long positions will start giving back unrealised profits when caught in a bull trap. In that case, some traders may struggle to keep their emotions in check and be susceptible to trading mistakes like keeping the long position open in the hope that the price may reverse once again only upwards this time.
If the price goes above a resistance level or previous swing high in a downtrend, keep an eye out for bull traps and consider going short (after your analysis confirms this) if the price falls below the prior swing high.
Bear traps are the opposite of bull traps in that they may fool traders into short-selling when the price breaches support. Bear traps, like bull traps, are characterised by a drop in trading volume as support is approached, and divergence between price and momentum indicators.
Bull trap patterns are well-known for luring traders into losing trades. On the other hand, bull traps can provide successful setups if you understand how they form and what they mean. Bull traps are characterised by low trading volume and divergence between the price and momentum indicators, such as MACD and RSI. We've shown how bull traps may be recognised and even traded profitably while minimising risks and maximising rewards.
Stop-loss orders may be used to limit risk while trading in a bull trap. Consider the position's size as well. Larger position sizes involve more risk.
A bear trap is a downward move at a support level that leads traders to go short in anticipation of a breakdown. But a failure to break support significantly can trigger a sharp upward reversal, resulting in losses for short sellers.
You can identify bull or bear traps in all markets. However, if you study historical data of different markets, you may find some markets where these traps appear more frequently than others.