In the stock market, a bull trap is defined as a false signal that convinces investors to buy stocks, pushing the prices up, only for the prices to fall soon after. This occurs when there is a large selloff after the initial rise in price, leading to heavy losses for bulls who bought into the rally.
So what causes bull traps and how can you avoid them? In this article, we will explore everything you need to know about bull traps.
What is a bull trap in stock?
The bull trap happens when there is a sudden price increase in price, only to be met with a decline soon after. Bull traps can affect specific assets or an index such as the S&P500.
Traders will want to ride the bull upwards just to get hurt when the stock price drops. In this scenario, they jumped on the bull trap and got thrown into a losing position.
The stock is declining in the long run but the short-term increase will capture FOMO investors looking to ride the bull that inevitably doesn't last.
What is the meaning of a bull trap in stocks?
A bull market in stocks is one where prices are rising and investors are optimistic. A bull trap is when this market is artificially created by professional investors to lure in new investors who will buy at high prices, only for the market to crash soon after, leading to heavy losses.
Bull trap example
To help illustrate how a bull trap works, let's look at an example. Let's say that you're watching the stock of XYZ company and you see that it's been trading in a range between $50 and $60 for the past few months.
One day, the stock breaks out above $60 and starts to rally. This looks like a bullish breakout and so you buy the stock at $61. However, soon after buying the stock, it reverses course and starts to head back down.
This is an example of a bull trap. If the market continued going up, it would be a bull market. But because it reversed and started to head lower, it was a trap that caught many investors off guard.
How a bull trap works
The way a bull trap can work is that investors see a stock moving higher and believe that it will continue to do so. They buy the stock, only to see it quickly fall back down. This can happen in a matter of days or even hours.
The key here is that the stock never really had the momentum to sustain its move higher. It was simply a false move that tricked investors into buying.
This can be caused by several different things. It could be that there was some short-term misinformation that caused the stock to pop higher. It could also be caused by a new product launch that initially had great sales but is later recalled. There are many different ways that a bull trap can occur.
The important thing to remember is that a bull trap is not necessarily indicative of a bearish market. It can happen in both bull and bear markets. This is because these traps are meant to capture short-term trading opportunities and not long-term investments.
How to identify bull trap
There are several ways to identify a bull trap. First, look for a stock that has been rising steadily for a period of time. This could be days, weeks, or even months. If there is a longer time span, it is less likely to be a bull trap.
This is because a bull trap is typically a short-term phenomenon. Next, look for a stock that starts to rise rapidly for no apparent reason. This could be due to a rumor, piece of news, or analyst upgrade.
Whatever the reason, it should not be based on any fundamentals of the company. Finally, look for signs that the stock is overbought. This means that the price has risen too far, too fast, and is now overextended. If it is overbought, there will likely be a sell-off soon.
What to look for
There are a few key things to look for when trying to identify a bull trap. First, you want to see a significant increase in volume followed by a sharp price reversal. This is an indication that there are more sellers than buyers in the market, which can lead to a further decline in prices.
Another thing to look for is a false breakout above a previous resistance level. This occurs when the price breaks out above a key level of resistance, but then quickly reverses and starts to head lower.
This can be a sign that the bulls are losing control of the market and that prices are about to head lower. If you see these two things happening in the market, then there's a good chance that you're looking at a bull trap. And once you identify one, then you can start thinking about how to trade it.
What happens after a bull trap?
Well, typically prices will continue to head lower after a false breakout above resistance. This is because the bulls have been fooled into buying at high prices and there are now more sellers than buyers in the market.
So, if you see a bull trap forming, then you can look to short the stock or buy puts to take advantage of the falling prices.
Is a bull trap bullish or bearish?
A bull trap is a bearish signal masquerading as a bullish one. It is designed to trick investors into buying stocks at high prices when the stock is enviably going to trend downwards. The short-term trade is bullish but the stock itself is bearish.
Bear trap vs bull trap
It's best to think of a bull trap as a bearish reversal pattern that can occur during an uptrend. Many times, novice traders will see the stock moving higher and think it's time to buy when in reality, it's about to fall in price.
When compared to a bear trap, a bull trap can be more dangerous because investors and traders will often be caught buying at the top. This can cause people to panic and sell when they realize they've been tricked and the stock starts to fall.
Overall, both of these traps can be avoided by carefully monitoring the market and using technical analysis to spot potential reversals. With a little practice, you'll be able to avoid these pitfalls.
Conclusion
A bull market is often filled with joy and euphoria. To see a sudden uptick in price can cause even the most experienced traders to let their guard down. This is where the bull trap comes in. It's a false signal that lures traders into a losing position.
The illusion of a green joy ride to riches can quickly turn into a red nightmare. So, the next time you see prices spiking up, take a step back and make sure it's not a trap. To prevent yourself from falling into these traps, make sure you invest in undervalued companies with strong competitive advantages.
If you are a long-term investor, you don't have to worry as much but it's still best to stay vigilant as you enter positions.