1. What is a bull trap in trading?
In trading, a bull trap occurs when traders buy an asset thinking its price will continue to rise, only to see it fall significantly after reaching new highs.
Bull traps occur during times of market uncertainty or when false information is circulated about a specific asset. It's called a bull market "trap" because clueless traders are led to believe that an asset that is falling is actually rising. This false sense of security can lead to significant losses.
When a bull trap is suspected, traders should exit the trade immediately or establish a short position. Stop loss orders can come in handy in these situations, especially if the market is moving quickly, to avoid getting carried away by emotion.
Related: Cryptocurrency Trading Basics: A Beginner’s Guide to Cryptocurrency Order Types
Like many things in trading, identifying bull traps can be difficult. However, the best way to avoid bull traps is to pay attention to warning signs — such as low volume breakouts — ahead of time. We discuss this further below.
2. How do bull traps work?
Bull traps can have serious consequences for those who buy during a perceived reversal.
Let's say you're looking at a chart of an asset that's in a downtrend. After some time, the price reaches a point where it begins to move sideways within what is called a "range."
During this period, bulls and bears are at war as they try to push the price in opposite directions. The bears are trying to push the price to new lows, while the bulls are trying to keep the price rising.
At some point, as the bears win, the price breaks below that range and the price drops to a new low. However, just when the downtrend seemed about to resume, the bulls came back and pushed the price back to the previous highs.
Many traders view this as a bullish reversal and start buying, thinking the downtrend is over. Unfortunately, this is usually just a temporary move and prices quickly resume their downward trend, resulting in heavy losses for those who bought at or near the top.
What does a bull trap mean in the cryptocurrency market?
Also known as a "dead cat rally," bull traps often occur in cryptocurrencies due to a rapid recovery.
In cryptocurrencies, bull traps work the same way as in any other market. For example, if the price of an altcoin has been rising steadily over the past few days, you might think it will continue to rise. You buy some and wait for the price to rise so you can sell at a profit.
However, on the contrary, you find yourself in a losing position. You witness a downtrend and then wait for a bullish reversal, at which point you can buy the dip thinking you are purchasing an asset at a reasonable price. The trap manifests itself when the price pulls back and returns to the downtrend.
The role of psychology in bull traps
Bulls chase and ride the momentum, and all is well until the next bear market returns.
When this happens, they may fall into a bear trap and may close their position at a loss. Investors accustomed to bull market trading may fall into the trap of buying high and selling low due to a one-way mentality (strictly bearish or bullish). Experts recommend having a bi-directional mindset to be successful in both bull and bear markets, as this allows for greater profits in long-term trends.
What is a bull trap?
Bull traps are used by day traders and long-term investors to take advantage of unsuspecting market participants.
For day traders, a bull trap can be an opportunity to short a security when it rebounds to its previous highs. The price will then resume its downward trend, bringing profits to the trader.
For long-term investors, a bull trap can be an opportunity to buy a security at a lower price on a pullback after a rally. They are then able to stay safe for the next uptrend.
3. What are the causes of bull market traps?
Many factors lead to bull market traps, one of the most common being a lack of buying on a rally to previous highs.
Weak buying volume indicates that there is not much interest in a particular low-priced security and that bulls are not enough to push the price higher.
Another common cause of bull traps is false breakouts from consolidation patterns. The price broke out of an upward range but then quickly retreated and resumed its downtrend.
4. How to identify bull market traps
Here's how to spot a bull market trap with some telltale signs:
RSI divergence
A high RSI may indicate a potential bull or bear trap.
The Relative Strength Index (RSI) calculation can be used to identify possible bull or bear traps. RSI is a technical indicator that can help determine whether a stock or cryptocurrency asset is overbought, underbought, or neither.
RSI follows the following formula:
Calculations typically cover 14 days, but can be applied to other time frames. This period has no effect in the calculation because it is removed from the formula.
In the context of a possible bull trap, high RSI and overbought conditions indicate increasing selling pressure. Traders are eager to pocket their profits and are likely to close their positions at any time. Therefore, the first breakout and uptrend may not indicate continued price increases.
Insufficient volume gain
When a market does break out to the upside, volume should increase significantly as more people buy as the price of the security rises.
If there is little or no increase in volume on a breakout, it indicates there is not much interest in the security at that price and the rally may not be sustainable.
Price increases without a significant increase could also be due to bots and retail traders competing for position.
lack of motivation
When a stock experiences a large drop or gap with a huge red candle, but then rebounds very modestly, it indicates a bull trap.
The natural tendency of the market is to move in cycles. When it reaches the top of a cycle, it's usually a period of consolidation as bulls and bears fight for control.
This lack of momentum can be seen as an early warning sign that the market is about to reverse course.
Lack of trend breakout
A price decline is represented by a series of lower lows and lower highs.
Trends in stock prices don't always change when progress is made. As long as the price does not rise higher than the recent lower highs, the downtrend remains intact.
Lack of confirmation is one of the most common mistakes made by those who fall into bull market traps. They should already suspect that if the current high does not exceed the previous high, then it is in a downtrend or range.
This is often considered "no man's land" and one of the worst places to start buying unless you have a good reason to do so.
While some traders may be disappointed by this, most are better off waiting for confirmation and buying at a higher price than trying to "get in early" and get stuck.
Retest of resistance levels
The first sign of an impending bull trap is strong long-term bullish momentum, but rapid reaction to specific resistance areas.
When a stock establishes itself in a strong uptrend with little bearish pressure, it means buyers are pouring all their resources into it.
However, when they reach a resistance level that they are unwilling or afraid to break, the price will often reverse before moving higher.
Suspiciously huge bullish candlestick
In the final stages of a trap, a huge bullish candle usually takes up most of the immediately left candlestick.
This is usually a last ditch effort by bulls to take control of the market before price reverses. It can also happen for several other reasons:
Big players deliberately push prices up to attract unsuspecting buyers.
New investors believe a breakout has occurred and start buying again.
Sellers are deliberately allowing buyers to dominate the market in the short term by allowing limit sell orders to be accepted above the resistance zone.
range formation
The final characteristic of the bull trap arrangement is that it creates a range-like pattern at the resistance level.
When an asset's price moves within a certain range, it is said to bounce back and forth between support and resistance levels.
Because the market may still be making smaller, higher highs, the range may not be perfect, especially at the high end. However, the beginning of the bull trap is visible as the previously mentioned large candle forms and closes outside of this range.