Market trends can be misleading. You may think that the market is moving in a particular way only for it to change course.
Most traders try to use technical indicators to have a better picture of where the market is going, but this is not sufficient. If it was, every trader would be a millionaire.
One of the ways traders can be misled in the market is through bull traps. Just like with any other chart pattern or trading approach, it takes practice to trade or avoid bull traps. In this article, we'll look at bull traps, why and how they happen, and the ways you can avoid them.
A bull trap is a misleading chart pattern that indicates that a stock that has been in decline for some time has reversed and is moving upward when in reality, the trend will continue to decline.
Bull traps occur when there is a sharp rise in the price of a stock after a downward trend. This rise is usually short-lived and followed by a much steeper decline.
It is called a bull trap because the seeming price reversal makes traders believe that a bullish run has started.
This makes inexperienced traders rush into the market. They anticipate that price action would continue its upward movement only for the trend to start a bearish run and decline. This change in price action to a bearish run traps the bulls as they cannot get out easily unless they do so at a loss.
A sudden spike in the price of the security followed by a quick selloff.
As investors jump in to take advantage of the sudden price increase, their buying power is insufficient to sustain the rally. This results in a decrease in trading volume, thereby leading sellers to take over resulting in a further decline in the price of the security.
Usually when the price of a security reverses upwards this may be due to a change in fundamentals such as:
Technical factors such as reaching key support levels, or technical indicators indicating that the stock is oversold may also result in a trend reversal. When there is a lack of fundamental or technical support for the price increase, this is likely a bull trap.
A price gap is a chart pattern that shows a significant price increase or decrease between two trading periods with no trading in between.
Price gaps occur when news or a significant event causes a stock's price to fluctuate dramatically. Because trading periods have not been 'filled', this usually indicates that the price action would be unsustainable.
It is difficult to recognize bull traps because they can only be known after the fact i.e. after they have occurred. However, there are several pointers you can use to avoid getting ensnared in one.
A bull trap can be avoided by doing the following:
Trading on fundamentals makes you ignore any short-term price fluctuations.
If you are trading a stock based on its fundamentals, you will be less worried about a bull trap because you are more concerned about the stock's long-term potential.
Usually when a stock reverses a price trend upwards, the best thing to do is to wait on the sidelines and look for any potential signs of decline.
You can use technical indicators such as RSI, parabolic SAR, trading volume, etc. to give you a better perspective.
Don’t follow the herd and get caught up in the hype.
It is never a good investment strategy to jump on a stock just because it is rising. Patience is a virtue, especially in the stock market.
Sticking to your trading plan helps you avoid trading more frequently. The less you trade, the lower your risk of incurring losses.
If you have a time horizon of 5 years or 10 years for security, then short termed bull traps will not be as worrying. You will see the price declines as an opportunity to dollar-cost average and accumulate more of the security at lower prices. This would reduce the average cost of your investment overall.
Trading is 20% strategy, 80% emotions.
This implies that the success of your trading is hinged on how well you can master and control your emotions. It is easy to get swayed by price trends in the markets, but putting things in perspective helps you to avoid misleading trends like bull traps.
When a stock is reversing upwards ask yourself: Why?
Perhaps it could be:
Asking questions to give you a more holistic view helps in putting your emotions in check.
A stop-loss is an order to your broker to execute a trade when the price of a security reaches a certain price.
Using stop-loss is a good way to reduce the risk of loss that comes with bull traps. You can place a stop-loss order above the recent low to control risk if the price reverses and continues to move lower.
A bull trap teaches you that purchasing at the first potential sign of a new uptrend can be risky.
Because there is little overall purchasing pressure to begin with, many of these attempts to advance may fail.
As the price moves above a resistance level or prior swing high within a downtrend, you may want to keep an eye out for bull traps and consider entering a short position if the price begins falling below the resistance level or prior swing high.
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