A bull trap is a false buying signal that occurs when an equity that has been in a declining pattern quickly reverses direction. This move gets the attention of investors and traders who buy the equity thinking this is the beginning of a bullish trend. However, instead of continuing to move higher, the price of the equity reverses to levels below the prior low. When this occurs, bulls who jumped into a trade believing the equity would move higher are “trapped” on the losing side.
In this article, we’ll help investors understand what a bull trap is, including giving an example. We’ll also explain why fundamental analysis is one reason why investors fall into a bull trap. We’ll also explain why a bear trap is the opposite of a bull trap, why bull traps affect investors as well as traders, and strategies to avoid falling into a bull trap.
What Is a Bull Trap and How Does it Work?
A bull trap happens when the price of a security that has been in a downtrend makes a sudden and significant move higher. This action draws the attention of interested investors and traders who begin to buy shares of the stock. This is when the trap occurs. Rather than continuing to move higher, the equity reverses in price and falls below its prior level of support. A bull trap can also be fueled by short-sellers who are forced to buy back their shares which can create a short squeeze and drive the price up artificially.
As an example, let’s say the stock of XYZ company was trading at $50 a share. However, for a variety of reasons, the stock falls to a price of $35 over the span of a few months. An informed investor may believe the sell-off has become too extreme. So when the stock begins to make a move to $35, investors rush back in believing the stock is headed back to $50. However, instead of going to $50 the stock reverses and falls below the prior support level of $30.
Why Do Investors Fall Into a Bull Trap?
Understanding this brings up the notion of fair value (or valuation). Many investors use different fundamental metrics such as price-to-earnings (P/E) ratio, price-to-book ratio, and price-to-earnings with growth (PEG) to assess if a stock is undervalued, valued properly or overvalued.
If investors see a stock trading below its fair value, they may rush to purchase shares at what they perceive to be a discount. But as every investor knows, the price movement on a stock is not always rational, and that’s why investors need to take steps to confirm that the price movement is real.
What Is the Opposite of a Bull Trap?
The opposite of a bull trap is a bear trap. This is a false selling signal that occurs when an equity that has been in a bullish pattern quickly reverses to the downside. Investors and traders sell the stock thinking that the rally is over. However, instead of continuing to fall, the stock reverses and moves past its prior high.
Do Bull Traps Only Apply to Traders?
Yes and no. Long investors intend to hold a stock for at least 12 months. And many bullish investors hang on to their positions for much longer. With that in mind, they will be less concerned about daily price movement. They are buying the stock on the belief that it will be higher by the time they are ready to sell.
On the other hand, many long investors add to their position over time. The most effective way to do this is to buy equities when they are trading at a discounted price. In this way, they can lower the average cost they pay for shares. Buying into a bull trap will have the opposite effect and can hurt their total return.
How Can Investors Avoid a Bull Trap?
The most common way for investors to avoid a bull trap is to look for confirmation of the signal. For example, investors should see if there has been any new news about the stock that may be contributing to the bullish price movement. Sometimes a stock may move higher as part of a “halo effect” from a different stock within its sector.
Avoiding a bull trap also requires that investors overcome FOMO (fear of missing out) which can be difficult. There’s plenty of evidence to show that the largest percentage gains tend to happen at the beginning of a reversal. So traders want to jump into a trade at the earliest possible moment to capture those gains. Unfortunately, that’s also the perfect condition for a bull trap.
To help with that, traders should set a firm stop-loss order (also known as a stop order) just below the breakout level. This type of order automatically issues a market order which in this case would cause a stock to be sold once its price hits that target price.
A better strategy is to look at trading volume. It’s common for a bull trap to occur due to low trading volume. So if investors can confirm that the equity is trading around its average daily volume (if not a little higher) they can have more confidence that a genuine reversal is taking place.
A Final Thought About Bull Traps
If you’ve been investing for any amount of time and haven’t fallen into a bull trap or two consider yourself fortunate. Bull traps happen because they have the appearance of being real. And at the core of most of these traps is investor emotion.
Investors are always told to leave emotion out of their trading or investment decisions. However, there are times when confirmation bias sets in and we see what we want to see. The good news is that by taking a few simple steps, investors can protect themselves against the downside risk of a bull trap.
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