- A bull trap is a false signal that prices are going to continue to rise.
- A bull trap can leave bullish traders holding onto losing positions and lead to missed opportunities.
- RSI, MACD and Bollinger Bands are indicators used to identify bull traps.
- By looking at price action, traders can often spot this support and resistance level before it happens.
- Having a plan, using stop loss and managing risk are some techniques to avoid bull traps.
A bull trap is a dreaded event for any trader. It occurs when the market rallies and price action appears to be headed in an upward direction, only to reverse suddenly and sharply, leaving those who bought at the top feeling trapped.
Bull traps can be difficult to identify, but there are certain red flags that can warn you of their presence. In this blog post, we’ll discuss what bull traps are, how to identify them, and how you can avoid them. We’ll also offer some tips on how to stay ahead of the curve in today’s markets!
What is a bull trap?
A bull trap is a false signal that prices are going to continue to rise. They often occur at the end of a price trend, when prices have risen to a certain level and then suddenly drop.
This can leave bullish traders holding onto losing positions, as they had expected prices to continue to increase.
A bull trap can be used by both day traders and long-term investors. Day traders may use it to enter into short positions, while long-term investors may use it to add to their existing positions or to initiate new ones.
The difference between a bull trap and a bear trap is that a bull trap is a situation in which prices rise to a new high, only to reverse and fall back down. A bear trap is the opposite; it’s a situation in which prices fall to a new low, only to reverse and rise back up.
While bull trap and dead cat bounce are two terms that may often be used interchangeably, they actually have different meanings. A bull trap is a false signal that occurs during a downtrend, while a dead cat bounce is a temporary rebound that happens during an overall downtrend.
What causes a bull trap?
- Exhaustion: This happens when prices have risen to a point where there are no more buyers left, and the only people left holding the stock are those who are waiting for a chance to sell. When there are no more buyers in the stock market, prices will start to fall.
- Failed breakout: A bull trap can also occur when prices break out of a previous trading range, only to fail and return back inside the range. This often happens when there is not enough buying support to maintain the breakout.
- Profit-taking: Another cause is when traders take their profits at key resistance levels, causing prices to fall back.
Low trading volume can sometimes be a sign that a bull trap is forming. However, it’s important to remember that there can be other reasons for low volume periods. For example, low volume can often occur during holiday periods or at night when markets are closed. So, it’s important to look at other factors before making any decisions.
What can happen to traders falling for a bull trap?
As we mentioned before, a bull trap can leave bullish traders holding onto losing positions. But that’s not all. It can also lead to missed opportunities. This is because when prices suddenly drop, it can be difficult to enter into new positions.
So, not only can this cause losses, but they can also prevent you from making profits.
How to identify this money losing trap?
- Look for a reversal candlestick pattern: This is one of the most reliable ways to identify a bull trap. Some common reversal patterns include the head and shoulders, double top, and triple top.
- Check the volume: When prices start to reverse after a period of rising, there should be an increase in volume. This is because more traders are selling the stock, which causes prices to fall.
- Look for divergences: Another way to identify a bull trap is to look for divergences on the chart. This happens when the price action and indicators such as the MACD or RSI are moving in opposite directions. Divergences are a sign that the current trend is losing momentum and might be about to reverse.
- Pay attention to support and resistance levels: Bull traps often occur at key support and resistance levels, so it’s important to watch out for these levels on your chart. If prices start to reverse around these levels, it could be a sign that a bull trap is forming.
- Use Fibonacci retracements: Fibonacci retracements are another tool that you can use to identify bull traps. These levels are based on the Fibonacci sequence, and they often act as support and resistance levels. If prices start to reverse around these levels, it could be a sign that a bull trap is forming.
There are a few technical indicators that can help you identify bull traps.
- The first is the Relative Strength Index (RSI). The RSI is a momentum indicator that measures whether prices are overbought or oversold. If the RSI is above 80, it means that prices are overbought and may be ready to fall. If the RSI is below 20, it means that prices are oversold and may be ready to rise.
- The second indicator is the moving average convergence divergence (MACD). The MACD is a trend-following indicator that uses two moving averages to generate buy and sell signals. (MACD line: 12-Period EMA – 26 Period EMA. Signal Line: 9-Period EMA). If the MACD line crosses above the signal line, it is a bullish signal. However, if the MACD line crosses below the signal line, it is a bearish signal.
- The third indicator is the Bollinger Bands. The Bollinger Bands are a volatility indicator that uses two standard deviations to calculate a band around a simple moving average (usually 20 periods). If prices touch or move outside of the Bollinger Bands, it is often seen as a signal that prices are overbought or oversold and may be ready to reverse.
Common bull trap patterns
There are a few common bull trap patterns that traders should be on the lookout for:
- Head and shoulders patterns
- Engulfing candlesticks
Traders must know how to identify price patterns mentioned above to avoid any mishaps.
Examples of a bull trap
Let’s take a look at a couple of examples:
- The first example occurred at the end of a price trend. Prices had been rising for some time and then suddenly fell, leaving bullish investors holding onto losing positions.
- The second example occurred during a breakout. Prices broke out of the previous trading range, only to fail and return back inside the range. This often happens when there is not enough buying support to maintain the breakout.
- A bull trap fools traders into thinking that prices will continue to rise when they actually start to fall. So its advisable to be cautious and not fall into the bait.
How to avoid bull traps
- Have a plan: One of the best ways to avoid them is to have a trading plan. This should include your entry and exit points, as well as your risk management strategy. Having a plan will help you stay disciplined and stick to your rules.
- Use stop-loss orders: Another way is to use stop-loss orders. A stop-loss order is an order that automatically sells your position when it reaches a certain price. This can help you limit your losses if the stock price starts to fall.
- Take profits at key levels: Another way to avoid bull traps is to take profits at key support and resistance levels. This can help you lock in your gains and avoid giving back all of your profits.
- Be patient: It’s important to be patient when trading. Don’t try to force trades, and wait for the right opportunity. Often, the best trade is the one that you didn’t make.
- Have a risk management strategy: Finally, it’s important to have a risk management strategy in place. This should include things like position sizing and stop-loss orders. Having a risk management strategy will help you limit your losses and protect your capital.
One of the key things to remember when it comes to bull traps is that they often occur due to psychological factors. For example, bull traps can occur when traders get too caught up in the moment and start buying without thinking. Or, they can happen when traders get impatient and try to force trades.
That’s why it’s so important to stay calm and patient when trading in the bull market. It can be easy to get caught up in the excitement of a bull market, but it’s important to remember that bull markets can quickly turn into bear markets. So, always stay disciplined and don’t let emotions get in the way of your trading strategy.
Price action and bull traps
Price action trading is a type of trading that relies on technical analysis. This means that traders look at the price movement of an asset to try and predict future upward price movement or downward price movement.
One of the things that price action traders look for is “bull traps”. This is because bull traps often occur at key levels, such as the support and resistance level. So, by looking at price action, traders can often spot this support and resistance level before it happens.
Final few tips
To reinforce our earlier points, here are a final few tips to help you avoid bull traps:
- Pay attention to the resistance level and be cautious when prices are near it.
- Look for signs that the current trend is weakening, such as lower highs or higher lows.
- Be on the lookout for bearish reversal patterns, such as head and shoulders patterns or engulfing candlesticks.
- Watch for indicator divergences, as they can signal that the trend is about to reverse.
- Don’t be afraid to take some time out of the market if you’re feeling uncertain. It’s better to miss out on a few points of upside than to get caught in a bearish price reversal.
Bull traps can be a frustrating experience, but they are an inevitable part of trading. By being aware of them and taking steps to avoid them, you can help keep your portfolio safe. So, make sure to keep these tips in mind next time you’re trading!