What is a bull trap in trading and how to handle it

“Bull trap” or “bullish reversal” means a change in the trend at the highs of a particular trading instrument, be it Forex trading, financial derivatives, etc.

Every trader can encounter a situation on the financial market when quotes overcome the resistance level, after which active growth continues for some time. However, soon the instrument reverses and moves in the opposite direction, knocking out stop losses. This false breakout, where investors jump mistakenly to open buy positions, is called a bull trap.

Bull traps can be particularly deceptive during a bear market, where false signals may lead traders to believe a downward trend is reversing.

The article examines in detail the reasons for the emergence of the pattern, as well as options for how not to fall a victim of this trap, catching buyers. By learning the types of bull market reversal, you will save your capital and increase it.

LiteFinance will help you with this.

The article covers the following subjects:

What is a bull trap and why does it happen?

Bull Traps in trading is a pattern that is represented by a false impulse breakdown of resistance amid volumes moving on the downward path. This price decline is caused by selling pressure, which is when a large number of investors are selling low their holdings of a security at the same time, causing the price decline. The selling pressure can be triggered by various factors, including a change in market sentiment, the release of negative news, or the realization that the security is overvalued. The trader needs to spot this bearish formation in a bull market when the initial buying spurts occur. The bull traps occur because buyers do not have the strength for further growth. Mostly this happens due to profit taking by market participants. In addition, pressure on the price action is exerted by the opening of positions by short sellers who do not want to miss the opportunity to earn by taking advantage of the situation, and return the quotes below the resistance level.

Why below the resistance? The answer is simple. Because stop-losses of the buyers are placed in this zone. However, the downtrend resumes, and traders triggering serves as fuel for the further downward path.

Therefore, in order to avoid falling into the trap, before opening a long position, you need to pay attention to additional technical indicators that confirm a breakout and emphasize the growing volume of purchases. You can analyze candlestick patterns and identify divergence with the following technical indicators:

One of the key features that these technical indicators have in common is that they show the appearance of potential bull and bear markets divergences.

Divergence in the financial markets means that the price moves in the chart do not match the technical indicators. In simple words, the market participants push prices up in the chart, while the indicators are declining, and vice versa.

How Bull Traps Happen

Bull traps happen when there is a false signal of a trend reversal, causing traders to buy into a market that is actually still in a downtrend. This deceptive scenario can be triggered by various factors, including misleading technical analysis indicators, unexpected news events, or even deliberate manipulation by major market players. One common catalyst for a bull trap is a phenomenon known as a “dead cat bounce,” where the price of an asset temporarily rises after a sharp decline, only to resume its downward trajectory.

When a bull trap occurs, traders who have entered long positions may find themselves caught in a losing trade as the price moves against them. This often leads to a surge in selling pressure, as traders scramble to close their positions and limit their losses. A classic sign of a bull trap is a lack of increased volume during the supposed breakout, indicating that the upward price movement lacks genuine buying interest. Additionally, a divergence between the price action and technical indicators such as the Relative Strength Index (RSI) can serve as a warning that the bullish momentum is not sustainable.

Examples of bull trap

In the daily chart of Apple Inc. you can see a typical example of a bull trap work, which is characterized by the following features:

1. The formation of a bearish divergence in bull conditions when the initial buying spurts occur on the RSI (relative strength index) indicator, which is an early signal for a price reversal at the top.

2. A drop in trading volumes at the situation when the price breaks out of the resistance level, which indicates a decrease in consumer demand and profit-taking by participants.

3. Formation of bearish Engulfing and Dark Cloud Cover patterns at local highs, which signal the opening of short sales by bears.

Another example of a bull market reversal can be seen below in the daily GBPUSD chart. In the current situation, the following characteristic features served as warning signs of emerging danger for the buyers who open long positions:

1. The MACD indicator warned in advance about the imminent price falls, forming a bearish divergence.

2. The volumes began to decrease, just like in the first example, while the quotes grew. This should alert retail traders, as this is a warning about the bear markets seizing the initiative.

3. The confirmation signal was the emergence of the bearish Hanging Man pattern, which is a reversal candlestick pattern formation at the top.

Paying attention to the above factors would allow market participants not only to avoid falling into the potential bull traps but also to increase their capital by opening a short position in the instrument above the indicated resistance level.

We can see a great example of a bull trap work in the daily BTCUSD chart of forex trading. The picture below similarly shows a bullish rally followed by strong resistance from buyers. Here, the bulls were twice driven into a trap after the asset breaks out impulsively of resistance, however, in both cases, quotes returned back. The following factors contributed to this:

1. The formation of a bearish divergence on the Stochastic indicator.

2. Consistent decline in trading volumes.

3. Formation of a bearish Engulfing candlestick pattern, which is a reversal pattern at the top.

How to identify a Bull Trap — Bull Trap technical analysis

Spotting a potential bull trap is easy if you know how to do it. Be sure to use one or more of the above indicators and monitor the trading volume on a particular financial instrument. In addition, it would be great to study the classic patterns of reversal at the top within candlestick investment research, for example, “bearish engulfing”, “hanging man”, “evening star”, and “dark cloud cover”. The combination of indicator and candlestick pattern analysis will help you avoid becoming bull trap fools, as well as save and increase capital.

Below we will give a step-by-step instruction for identifying a bullish reversal using the BTCUSD chart as an example.

1. Let’s identify the bearish divergence in the chart using the technical analysis indicators MACD, RSI, and Stoch.

In the BTCUSD chart, you can see that the MACD indicator showed a divergence earlier than the RSI and Stoch. Therefore, traders had the opportunity to prepare in advance and avoid falling into the first trap, locking in their particular investments either with profit or at breakeven.

However,slightly later the RSI and Stoch indicators warned of the impending second bull trap, which was accompanied by a second impulse breakout of the resistance level amid the declining volumes.

2. Speaking of volumes. The second important feature is market conditions. An analysis of supply and demand, as well as an estimate of trading volume, will also help avoid this tricky trap. Low trading volume can be one of the factors that contribute to a bull trap.

3. A key component in identifying a bullish reversal is the analysis of candlestick patterns.

In the current situation, we can see that the bearish engulfing patterns have formed at new highs after the bullish dynamics. Moreover, the patterns were formed on impulse breakouts of the resistance level in both the first and second cases.

4. Setting stop-losses.

It is important to remember about risk management when trading on financial markets and to place stop loss orders without fail if you have already opened a position. Even if you fall into such a trap, there will be an opportunity to save capital with small losses. Otherwise, you have to face a high risk of losing money rapidly.

Combining these actions with consistent and clear analysis will avoid the market trap that many traders and investors lose money on.

Bull trap chart patterns

In this section, we will look at the types of bull traps that can be found in the charts. Let’s study the nuances that should be taken into account when analyzing certain types of this pattern.

Pattern №1 – Springing Double Top

This is one of the traditional patterns where after reaching a certain level, quotes reverse back to the downward trend. In the AUDUSD chart, at four points at local highs, there was an attempt to push prices higher, but it wasn’t successful. At the fourth point, a bearish tweezer top pattern was formed. The final confirmation of the trend reversal was the formation of the hanged man pattern. At the fifth point there was an irreversible capitulation of the bulls, from where the price values fall sharply.

Pattern №2

After a short period of consolidation, the asset makes a sharp jump up called a “piercing”, forming a tight bar to collect buy orders. However, this is a trick, after which the price falls. The EURJPY chart is proof of this. In addition, a strong reversal signal formed next — the hanging man pattern.

Why should you avoid bull traps and how to do it?

Avoiding bull and bear traps is essential for at least one major reason: saving your capital. Sometimes this is not easy, because before the trap occurs, the movement is in line with traders’ forecasts and the price moves in accordance with the trend. So most of the unsuspecting traders are already in a trap.

You probably have a logical question: how do I avoid becoming bull trap fools and still make money? Below you will find the ways to avoid these traps.

Method №1

First you need to make sure that this is not a false reversal. Confirm the breakout additionally with the help of various figures or candlestick patterns of trend continuation, such as the “bull flag” or the “three white soldiers”, “three bullish steps”, “separating lines” patterns.

Method №2

The point of this method is to confirm the breakdown with technical analysis indicators. You can use RSI, Stoch, MACD, but this is best confirmed by the continued growth in trading volumes. During a breakout, volumes should at least stay at the same level and continue to rise. If the reverse dynamics develops, it is more likely that bull traps are being formed with a purpose to collect as many buy orders as possible above the resistance level.

Method №3

Another method to avoid falling into bull traps is to analyze the close of the daily candle and the length of its shadow. Often on lower timeframes, the price can consolidate above the resistance level, and on the daily one, only the shadow of a candlestick pattern can remain. This means that the bulls did not have enough strength for an impulse breakout and a bull trap is more likely to form, after which the asset will begin to decline.

How to trade bull traps: the best strategies  

Let’s consider the most effective strategies for successful trading with the bull trap pattern. You can use these strategies to avoid falling into this market trap and profit from the situation.

Combination of indicators and candlestick analysis strategy

The point of the investment strategy is in the name. This method involves a combination of indicator and candlestick pattern analysis.

To be more precise, it uses chart analysis with the RSI, Stoch, MACD indicators and the volume indicator in combination with bearish and bullish candlestick analysis patterns.

The instruction for this strategy will be provided below through the example of the USDCHF daily chart:

1. First, in the chart, you need to identify the support and resistance levels

At first glance we see nothing suspicious. There is a quite predictable picture of a bullish trend. A model similar to a bull flag appeared on the left, however, after a breakout upward, the bulls fell into a resistance zone. That is, something prevented the situation with higher price. This was the first sign of a bull trap.

2. Next, using the “Indicators” section, you need to add the “Volumes” indicator to the chart

After adding Volumes, it became clear that the growth is accompanied by a decrease in trading activity, which is the reason for the deceleration of the bullish trend.

3. The next step is to choose one of the three oscillators

In this example, let’s take the RSI indicator, which is used by many market participants. Using this indicator, you need to determine how strong the bullish trend is and whether there is a bull trap in it.

The indicator analysis showed that the price is growing in the chart, but decreasing on the RSI, so we have identified a bearish divergence. This is an early signal for a price reversal at the top, and here we can safely say that a bullish reversal has formed.

4. Next, you need to do a candlestick analysis

It confirmed the transition of the trend from bullish to bearish. A lot of candlestick patterns have formed in the chart, which are reversal patterns at the top. In particular, it is necessary to note the appearance of the bearish engulfing and hanging man patterns, which indicate that there is strong resistance at this level and the bears have activated. Candlesticks with long tails up are called “shooting stars” and similarly emphasize catching buyers.

If you see a similar situation in a particular financial instrument, before entering the market, make sure in the similar way that this is not a bull trap.

5. Opening a short position

After the final confirmation of the bull trap pattern, you can open a short position at point 1 or 2. To comply with risk management, it is better to close the first half of the position at the nearest support level. Next, you need to watch for the appearance of bullish reversal patterns in the chart, for example, such as a hammer, an inverted hammer, an engulfing, a piercing, or a morning star. In our case, an inverted hammer first appeared in the chart. The reversal was confirmed by the bullish engulfing pattern, after which it is best to close the rest of the position.

With this approach, you can not only avoid the bull trap, but also make money, and the convenient LiteFinance web trading terminal will help you with this.

Turning Bull Traps into Profitable Opportunities

While bull traps can be costly for traders who get caught in them, they can also provide profitable opportunities for those who know how to identify and trade them. Here are some strategies for turning bull traps into profitable opportunities:

1. Short Selling: One way to profit from a bull trap is to short sell the asset when the price breaks out above the resistance level. By betting on the price to fall, traders can capitalize on the subsequent downward movement.

2. Trading the Reversal: Another way to profit from a bull trap is to trade the reversal. This involves buying the asset when the price reverses back down, taking advantage of the downward momentum.

3. Using Options: Options can provide a way to profit from a bull trap without taking on too much risk. For example, buying put options can allow traders to benefit from a decline in the asset’s price while limiting potential losses.

4. Hedging: Hedging can provide a way to reduce the risk of a bull trap by taking a position in the opposite direction of the trade. For instance, if a trader is long on an asset, they can hedge by taking a short position in a correlated asset.

It’s important to note that trading bull traps requires a high degree of skill and market knowledge, and is not suitable for all traders. Always use proper risk management techniques, including stop-loss orders and position sizing, to protect your capital and minimize potential losses.

Conclusion

In this article, we analyzed in detail the bull trap pattern, its varieties and the reasons this pattern appears. In addition, the article explores in detail the methods of avoiding such traps and presents an earning strategy with the purpose of preserving and increasing your capital.

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