In this article, we will look at one of these traps; why does it happen? Who is responsible for them? Why does it concern you, and can you outsmart it? We show you how you can profit from a bull trap trading strategy.
Some traps are set for you in the market. Shocking, but it is true. Not all losses are a random hand of the market’s probability model, and some are carefully crafted to take your money away.
You might find it challenging to wrap your head around why such a regulated industry as this traps traders like us. If you have been trading for a while, you’d have fallen prey to these traps repeatedly, and knowing much more about them is critical to your investment career.
There’s a famous phrase thrown around amidst technical analysis folks: “the trend is your friend,” this is advice always to follow the prevailing trend whenever you want to open a position.
While this is sound advice, it becomes irrelevant under some circumstances, such as trend reversals (because trends don’t last forever.) So, how do you make trading decisions when the price is about to reverse?
There is a common way most traders approach these market conditions. They often jump in because they don’t want to be left behind when a new trend is forming. The market manipulators are also aware of this, and they have come up with a perfect tool to cash in on this mass fallacy; it’s called the “Bull Trap.”
A bull trap is a pattern formed to “trap” buyers (bulls) into buying in a bearish trend, after which the price suddenly turns against them, and they are forced to close their position in a loss.
Various factors, including market manipulation, false or misleading information, and herd mentality, can cause bull traps. They can be challenging to spot, as they often involve a sudden and significant increase in the price of a security, making them appear legitimate to investors.
The term “bull trap” is used to describe this situation because it “traps” investors expecting the bull trend to start and lures them into making a poor investment decision.
The bull trap capitalizes on the mass psychology of retail traders and presents the same pattern often. Simply, it consists of suddenly pumping prices in a bearish trend to fool buyers into entering a position and go home with their money.
However, the pattern repeats often, and as a result, here are some tips we have gathered to help you spot it and avoid quickly submitting your cash to these liquidity providers:
One of the most common signs of a bull trap is a divergence between the security’s price action and its underlying technical indicators.
For example, if the price of a security is rising while its Moving Average Convergence Divergence (MACD) is falling, it could be a sign that the security is overbought and that a reversal is imminent.
Insider selling is when company executives or other insiders sell their shares of the company’s stock. If you see a lot of insider selling, it could be a red flag that the company’s management is not confident in the stock’s prospects.
A bull trap often involves a surge in trading volume, as market manipulators try to create the appearance of solid demand for the security. If you see a sudden increase in volume without a corresponding increase in the security’s price, it could be a sign of a bull trap.
Market manipulators may try to create a bull trap by spreading false or misleading news about a security. If you see news that seems too good to be true, or if the news doesn’t match the security’s price action, it could be a sign of a bull trap.
To avoid falling victim to a bull trap, it’s essential to gather information from multiple sources and do your research. This can help you get a more accurate picture of a security’s actual value and help you identify any potential red flags.
While these tips are not always guaranteed to help you avoid these trap moves, they can drastically decrease how often you fall prey to them and also improve your profitability in the long haul.
We’d be looking at the BTC/USDT chart (this is to show that the bull trap can be seen in every tradeable market, including cryptocurrencies!)
A little context: What we have here is a ranging market condition just after a series of bearish movements. A prominent high (marked with a rectangular box) has formed a resistance zone.
Suddenly, the price broke this zone in a bullish succession. This sharp move masquerades itself as a zone breakout, inviting buyers to join the move quickly.
Just as quickly as the “false” breakout appeared, the price spiked downward to force out buyers who had just been trapped. This is an example of a bull trap at work.
But looking at the chart, there are things to do differently to outsmart this trap move:
Looking at the chart, the price is forming a higher high but looking at the MACD, it is forming a lower high, presenting us with a divergence. Basically, the divergence shows that the upward thrust cannot be maintained, and the price will fall shortly.
By just paying attention to divergence on this chart, you would have saved yourself from losing your money to these traps. You have to backtest these on your chosen asset class well enough to get accustomed to it.
A bull trap can occur in any financial market, including stocks, bonds, commodities, and currencies. Bull traps can be particularly frustrating for investors because they often leave footprints that seemingly convince investors that the price is going to move up, especially by breaking major support zones.
However, there are several reasons why a bull trap may occur:
- False or Misleading Information
A bull trap can be caused by false or misleading information disseminated in the market. For example, a company may release false financial statements or make false claims about its products or services. This can lead investors to believe that the company’s stock is a good investment, only to be disappointed when the truth is eventually revealed, and the stock price falls.
- Excessive Optimism
A bull trap can also occur when investors become overly optimistic about the prospects of a particular asset or market. This can lead to overvaluation, as investors bid up the price of an asset beyond its intrinsic value. When optimism fades, the price of the asset can drop significantly.
- Market Manipulation
Sometimes, a bull trap may be intentionally created through market manipulation. For example, a group of traders (Known as market makers, liquidity providers, or market manipulators) may manipulate the price of a stock by buying and selling it among themselves to create the appearance of a bullish trend. Once the price has been driven up, they may sell their positions, causing the price to plummet.
- Reversal of Underlying Trends
A bull trap may also occur when the underlying trends that were driving the bullish trend in the market reverse. For example, if a stock has been rising due to solid earnings growth, a sudden downturn in the company’s earnings could lead to a reversal in the stock’s trend.
These are the major causes of the bull trap in the market, and they are mostly outside your control as a trader. You will have to execute your investment strategy while staying mindful of them.
Retail traders are often less experienced or have fewer resources than institutional investors. Hence, bull traps can significantly affect our trading activities.
One of the main effects of a bull trap on retail traders is the potential for significant financial losses. When the price of an asset falls after a bull trap, traders who bought at a higher price may find themselves with a considerable loss. This can be especially painful for traders who have leveraged their positions, as the losses can be magnified.
Even beyond the financial losses is the mental or emotional damage the bull trap can cause to a retail trader. It can be tough for retail traders to accept that they have been duped into buying an asset that is falling in value, and this can lead to feelings of frustration and anger.
While you cannot always avoid these moves, you can stack the odds in your favor by doing the following:
- Conduct Thorough Research – Backtest
One of the best ways to avoid bull traps is to conduct thorough research on the stock or financial instrument you are considering investing in. This includes looking at the company’s financials, analyzing its competitive landscape, and considering the overall economic climate. By thoroughly analyzing the potential risks and rewards of an investment, you can make a more informed decision about whether it is worth pursuing.
- Use Technical And Quantitative Analysis
This seems to be obvious. Technical analysis involves examining charts and other statistical data to identify trends and patterns that may indicate the direction of a stock or other financial instrument. By using technical analysis tools, such as trend lines and moving averages, you can better understand whether a stock is truly trending upward or if it may be headed for a bull trap.
- Consider The Fundamental Value
It is important to remember that stocks and other financial instruments are ultimately valued based on the underlying value of the company or asset. This means that you should not just rely on chart patterns and technical indicators but also consider the fundamental value of the stock or instrument. This includes looking at the company’s earnings, revenue, and growth potential.
- Diversify Your Portfolio And Strategies
Finally, one of the best ways to avoid bull traps is to diversify your portfolio. This means investing in various stocks, bonds, and other financial instruments rather than putting all your eggs in one basket. By diversifying your portfolio, you can spread the risk across a range of investments, which can help to mitigate the impact of any individual losses.
Bull trap trading strategy backtest
Can you backtest a bull trap trading strategy?
In this section, we try to profit from a bull trap by going short. All the short strategies are taken from our short strategies bundle which contains 3 strategies for three different ETFs: SPY, XLP, and SMH. Because they are behind a paywall we don’t want to reveal the trading rules.
Let’s start with the first strategy in SPY:
There are only 112 trades since its inception in 1993, but the average gain per trade is a pretty solid 0.72% and the win rate is 66%. But as expected, the return is pretty erratic because short is very difficult to trade. It doesn’t matter which asset you are looking at, short is almost much worse to trade than long.
Let’s go to the second strategy: XLP.
There are 218 trades, but the average is lower than in SPY: 0.3%.
The last and third strategy trades SMH:
Since its inception, there have been 188 trades, and the average was 1.25%.
Please keep in mind that all three bull trap trading strategies perform best when the market drops. As such, they might work a little bit like tail risk strategies in the stock market.
Here are short answers to the questions that are commonly thrown around the topic:
Bull traps are bearish. They occur in bearish trends but are characterized by creating a false bullish move to trap buyers before suddenly dropping and resuming the bearish trend.
The chances of a bull trap happening in more volatile markets are higher than in less volatile ones. However, the trap pattern presents itself under varying market conditions that we can’t give a specific statistic.
While most traders find some technical indicators like volume and MACD effective in detecting a bull trap, you will have to backtest which one works best for you, depending on the asset you are analyzing.
It’s essential to always bear in mind that indicators lag and can give false signals sometimes. Hence, it would be best if didn’t use them alone.
Bull traps can significantly affect retail traders, including financial losses and psychological damage. To protect themselves, retail traders should research and be aware of the potential risks and warning signs of a bull trap.
Since it is quite an important topic for you to grasp, here’s a quick recap of what we covered in this article: Firstly, you must be aware that there are traps in the market before you open any position.
Secondly, we covered how to spot the trap patterns using technical analysis, thorough research, and checking verified news. We also used what was taught to analyze a BTC/USDT chart.
Here’s something you should consider doing to hone this skill: it is advisable to go through the chart of your favorite security/asset and mark up the bull trap patterns while annotating how you would have avoided them using the tips discussed in this article. This way, you can learn faster and be sure you’ll be able to pull it off in real time.
Can You Backtest a Bull Trap Trading Strategy?
Yes, a bull trap trading strategy can be backtested. However, it’s crucial to note that short strategies, including those related to bull traps, can be challenging due to the inherent difficulties in short trading. Backtesting helps assess the historical performance of the strategy.
How to Avoid a Bull Trap?
To avoid falling victim to bull traps, traders should conduct thorough research, use technical and quantitative analysis, consider the fundamental value of the asset, and diversify their portfolios and trading strategies. These measures help in making informed decisions and spreading risk.
How Does Bull Trap Trading Strategy Backtesting Work?
Bull trap trading strategy backtesting involves assessing the historical performance of short strategies designed to profit from bull traps. Traders can analyze factors such as average gain per trade, win rate, and overall return to evaluate the effectiveness of the strategy.