What is a bull trap and how does it work?
A bull trap is a reversal from an upward rally. Learn more about bull traps including how to identify them and how to escape them, with examples, in this article.
What is a bull trap?
A bull trap is a reversal against a bullish trend that forces long traders to abandon their positions in the face of rising losses. It is called a trap because it often catches traders off-guard, and comes on the back of a strong market rally that looked likely to continue.
Bull traps are characterised by a trader or investor buying an asset as it breaks through a historically high level of resistance. Many breakouts above resistance are followed by increasingly higher highs, but a bull trap is characterised by a bearish reversal soon after the breakout.
How to identify a bull trap
It’s hard to identify a bull trap because normally after a breakout, an asset would be likely to increase in price, not reverse. However, what you can do is carry out technical analysis and fundamental analysis on the asset you want to trade.
Look for whether the asset is currently overbought, which could indicate a bearish reversal from the prevailing bullish trend. You could also wait before opening long position following a breakout, to see if the bullish trend continues.
A popular technical indicator to identify overbought assets is the relative strength index (RSI).
Bull trap example
In the below example, we’ve looked at the FTSE 100’s price movements. As you can see, it was moving in a relatively steady upward trend, with two peaks before realising a breakout above the historical high for this time period.
Normally, we might expect this breakout to result in a series of higher highs as the level of resistance has been breached. But, in this particular example, the breakout was actually a bear trap. If a trader had opened a long position shortly after the breakout, they would’ve quickly found themselves confronted by a bearish reversal against the prevailing trend.
How to escape a bull trap
The best way to escape a bull trap is set a stop-loss on your position as you open it. This will help you to prevent heavy losses if you’re caught out by a bull trap.
There are a few kinds of stop-losses to choose from, including standard, trailing or guaranteed. When trying to avoid a bull trap, a trailing stop would probably help you the most, because it will trail behind the current market value by a set amount of points, and it will automatically close your position if the market value falls by that set amount.
This will help you to lock in as much profit as possible, while also cutting losses early on into a bull trap.
How to trade a bull trap
You can trade a bull trap by opening a short position when you identify that a bear trap is in effect. You can go short with financial derivatives like CFDs. These enable you to take a position on an asset without having to directly own it, making them well-suited to shorting.
Bull trap trading summed up
- A bull trap is a reversal from an upward trend shortly after an asset breaks through a historical level of resistance
- Normally, a breakout above resistance might indicate that the prevailing trend will continue but this isn’t the case in a bull trap
- Traders might take a breakout above resistance as a signal to go long and buy the underlying market
- If this is the case, bear traps could result in a trader losing money as the price falls after opening a long position
- Stop-losses – particularly trailing stops – can help you to avoid bear traps and their negative effects on profits in your trading
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