A reversal known as a bull trap is one in which market players who were on the incorrect side of price movement are forced to quit their positions with unanticipated losses.
When buyers are unable or unwilling to maintain a rise above a breakthrough level, a bull trap is created. By looking for confirmation after a breakout using technical indicators and/or pattern divergences, traders and investors may cut down on the number of times they are caught in a bull trap.
What is a Bull Trap?
When there is ambiguity in the market or when there is widespread dissemination of incorrect information on a certain asset, bull traps are likely to emerge.
It is referred to as a “bull trap” because unsuspecting traders are persuaded to assume that an asset that is really experiencing a decline is actually increasing in value. This illusory feeling of safety might result in significant financial losses.
When there is a suspicion that a bull trap is being set, traders should get out of the transaction immediately or go into a short position. In these kinds of circumstances, stop-loss orders may be really helpful. Particularly when the market is moving quickly and you want to avoid getting carried away by your emotions.
Finding a bull trap may be challenging, as is the case with a number of other aspects of trading. However, the most effective strategy for avoiding bull traps is to be vigilant. And watch for early warning indicators, such as breakouts with low volume. Below, you’ll find additional discussion about this topic.
How Does it Work?
So, you’re studying a chart of a declining asset. With enough time passing, the price eventually settles. Into what is known as a “range,” or a narrow band of stability.
At this juncture, bulls and bears are fighting tooth and nail to move the price in their respective orientations. There is a fierce battle going on between the bears. Who want to drive the price to new lows, and the bulls, who are doing all they can to protect the price from falling any lower.
The bears eventually triumph, and the price drops to a new low, signaling a breakdown from the range. Whenever the bears have a chance to reclaim control, the bulls make a return and reclaim control, sending the price back up to the previous high.
A bull trap may take many forms, but there are certain telltale technical characteristics that might help you spot one:
- Either a downward trend or a mild upward trend, or the price is consolidating.
- The price rises above the previous high point or the resistance level.
- During this short period, the price is trading above the previous high (or resistance level).
- Afterwards, the price drops below the previous resistance level.
- Investors who have recently invested may want to dump their shares to avoid further losses.
- Since there was no reason to be optimistic to begin with, savvy investors may utilize the current high price as an entry point to sell. The price is lowered in part because of this factor.