Every trader should know about the bull trap because it is so common in markets like Forex, cryptocurrency, and the stock market. If traders aren't careful, it can potentially cost a lot. In this article, we will talk about Bull Trap and how to avoid it.
26 November 2020, | AtoZ Markets – In trading, Bull Trap means when price gives a false bull signal to go long. It can be seen as a failed attempt of breakout. In Bull Trap, the bearish trend appears to be over, and the price reversed its direction to bull for a short period then the market returns to the downtrend. It is also known as "upthrust", a term that came from Richard Wakeoff, the founder of Wall Street magazine.
Trader believed that the bearish trend was over and a new bullish trend started but not so, that's why it's called trap. The bullish signal caused traders to enter the market. Then they got caught in the trap and need to sell to get out at a loss. Due to greed, some trader jumps into the market too early, and then they get caught in a bull trap.
What Happens During A Bull Trap?
Bull trap seems very convincing to believe the end of a bearish trend. It is like a whipsaw; it goes up then quickly come back against the buyer. It is well known that it allows traders to engage in risky trades that almost always result in losses.
- The bull trap gives a strong reversal signal of downtrend attracting traders to trade the wrong side of the trend. Then they experience unexpected losses. Bull trap happens when traders fail to support a rally above the breakout level.
- Traders can generally avoid bull traps through additional confirmation signals like a reversal, gap up, breakout, or other technical signals.
- Bull traps usually occur during announcements or news events; the price shows short bullish moves on the chart due to volatility.
Bull Trap Chart Example
The bull trap can be in various forms. But, in below, three bull trap examples are given that look extremely bullish, breaking the resistance level, and then go to the downside.
Bull Trap Chart Pattern #1
First two bullish candlesticks break and close above the resistance level. It is a bull trap. But the next two bearish candlesticks close above the resistance level and approximately a shooting star or a bearish pin bar type of candlestick. Then the price continues to go down.
Bull Trap Chart Pattern #2
First bullish candlestick breaks the resistance level and goes up but eventually closes below the resistance level. It is a bull trap. It looks like a real bullish breakout which caused the trader to jump in. Then the second candlestick changes direction and forms a bearish candlestick. It closes below the resistance level with bearish momentum.
Bull Trap Chart Pattern #3
The first candlestick breaks the resistance level and rises but closes below the resistance level. However, the candlestick gives strong momentum breaking resistance. It is a bull trap. The next two candlesticks are bearish and also close below the resistance level. After the breakout, if the next 1 or 2 candlesticks are bearish, then there is an excellent chance of a bull trap.
How to Avoid Bull Trap?
In trading, large price falls often lead to sharp upward reversals. So, Bull trap lures traders to buy. Despite to bullish signal, the market goes to downtrend. Therefore, traders panic and sell their position with an unexpected loss. However, traders can practice the following habits to avoid falling into the traps.
Check the Volume
If asset value changes but the volume remains steady, then there is an excellent chance of a bull trap. Low volume breakouts also signal a trap.
Look for RSI Divergence
Relative Strength Index (RSI) is a momentum oscillator indicator. It measures the strength and weakness of a trend. If RSI is less than 25, it signals overbought market conditions. And, if RSI is greater than 75, it indicates overbought market conditions. If there is momentum then RSI will increase. If not, RSI will decrease. If price and RSI move in opposite directions, it means there is no significant momentum.
Do Not Buy in Resistance Levels
The trader should not buy trades at a resistance level, except if the price retests the level after breaking and confirming the start of a new trend. However, buying trades at the resistance level is riskier than buying at the support level.
Check the News
News plays a vital role in the trading market. If there is a sudden price movement with an average volume, traders should check the news before taking any trading action.
Use Stop-Loss Orders
There is no certainty in trading. No trader can be 100% sure about their trading decision. Moreover, the price action is often strong and rapid. So, traders should always use stop loss to limit their losses.
Trade Only in the Main Trend Direction
The trader should follow the trend to trade. But trading against the trend requires a high level of expertise and understanding of the market. So, new traders should not trade against the main trend.
Check the Next Few Candlesticks After a Breakout
After a bull breakout, traders should always check the next one or two candlesticks. If it does not continue the trend, which means it is a trap. Price action is the best way to read the market and avoid such traps.
Reversing Candlestick Patterns
It is essential to be familiar with reversing candlestick patterns such as engulfing candlesticks or shooting star or hammer patterns.
A bull trap is especially dangerous for bullish traders because the continuous rapid decline in prices after the false bullish breakout is often substantial, sometimes more than the initial drop. It can be challenging to trade when the price decline will stop and reverse then fall again, as traders interact emotionally.
Being able to identify the bearish trend is an excellent opportunity for bullish traders. But it is essential to be aware of the fact that the bull trap often occurs in markets.
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