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What is a Bull Trap?
A bull trap is a false signal that can encourage investors to buy an asset in the mistaken belief that a recent downward trend is now being reversed. They commit to buying this new position – or adding to existing holdings – but the upward move proves to be temporary, and the price starts falling again.
Techopedia Explains the Bull Trap Meaning
The clearest bull trap definition is when a market – or asset – experiences a short-term rally during an otherwise downward trend. Eager investors that get caught by this bull trap will mistakenly believe this mini rally is the start of a more prolonged move upwards.
They will buy into the asset – or increase their existing holding in it – but then the downward trend resumes, and they’re dealing with losses.
How Does a Bull Trap Work?
Generally, a bull trap can happen when particular investments are going through a difficult patch, but bullish investors believe brighter days are ahead. The asset in question – or the market – will have been on a downward trajectory for whatever reason. This could be something specific to that particular company or a global meltdown.
However, the price may start spiking back upwards during this period, with this move being enough to convince some investors that it’s the start of a sustained recovery. This temporary uptick can be caused by a variety of factors, including over-optimism about prospects and strategies employed by experienced traders.
Increased interest in the asset may push the price higher, but as the increase won’t be based on anything substantial, it will eventually start to fall again.
How to Identify a Bull Trap
This is not easy for anyone – and can be particularly tricky for beginner investors who are getting to grips with various market signals. However, there are often a few signs to look for that may indicate the upward price trajectory will not be sustainable.
A prime example is if trading volumes are low. An increasing price – but relatively few shares being bought and sold – can indicate the rally will be short-lived.
Another piece of evidence is if the price has gone above a prior high point or a resistance level. You can also pay attention to other technical factors, such as moving averages, which smooth out price data to better illustrate market trends and directions.
However, it’s important to remember that these are simply indicators. They are not fool-proof ways of spotting a potential bull trap but just tools to factor into your research.
You should also perform a reality check. Are there reasons to support the price increase? Has something happened in the wider market? If not, then be suspicious.
Causes of a Bull Trap
We have looked at the bull trap meaning, but what causes one to happen? It’s all down to the price of an asset being pushed up temporarily. There are several reasons why this may occur.
It may be down to market manipulation by some traders or investors acting on misleading information.
In other cases, it may simply be down to timing. Traders may be looking to buy at what they believe is a bargain price in the wake of a slowdown when the reality is there is further to fall.
Some more experienced investors, who realize the increases aren’t based on hard evidence, may use the inflated price as an opportunity to sell. Their decision to exit will end up driving the price lower.
Bull Traps and Investment Strategies
Experienced investors may look to turn bull traps to their advantage. However, trading them in this way is risky and certainly not for beginner investors.
For example, a trader who believes he’s spotted a bull trap may look to short the security as its price starts to rise and then profit from the subsequent fall.
There’s also the possibility of buying after a bull trap has occurred when the asset in question has fallen in value. At this point, it could become an interesting buying opportunity again.
Role of Psychology in Creating Bull Traps
As is often the case with investing, psychology can play an important role in both the creation of bull traps – and for people falling into them. The overwhelming emotion for investors who end up falling victim to bull traps is the fear of missing out on early gains as an asset begins a long-awaited recovery.
Getting in on the ground floor when the price starts to rise will maximize the potential return enjoyed. However, this point is notoriously difficult to predict with any degree of accuracy.
This eagerness to buy can make investors less inclined to analyze the reasons for the apparent sudden turnaround in fortunes and more susceptible to suffering losses.
Bull Trap vs. Bear Trap
A bull trap is when investors wrongly believe an asset’s price is rising, but it subsequently falls.
A bear trap, meanwhile, is the opposite. This is when the price is expected to fall, so the asset is sold, only for the price to rise.
Investors affected by bear traps may have sold it ahead of time or opened up short positions in the hope of benefitting from a falling price.
Examples of Bull Traps
An example of a historic bull trap was the dot.com bubble that occurred almost 25 years ago in 2000 and badly affected investors across the world. This period saw some technology stocks enjoy what appeared to be a temporary recovery during the bloodbath that happened when valuations collapsed after being inflated to unsustainable levels.
The upward ticks, of course, were very short-lived, and when the dot.com bubble burst, it wiped millions of pounds from stock markets around the world. Investors that had clung to the hope that the slight share price improvements witnessed were the first steps back would find out to their cost that this was simply a bull trap.
Another example came during the financial crisis in 2008.
In late October 2008, the S&P 500 Index (SPX) experienced a notable surge, fueling optimism among investors and traders who thought the market downturn had ended. This sense of optimism persisted as the US market continued to rise until November 4. However, the sellers quickly regained control, pushing the market to even lower depths.
Between November 4 and November 20, the index experienced a sharp fall of 25%. This swift decline in less than three weeks inflicted significant damage on the market, erasing much of the gains and optimism that had briefly flourished.
How to Avoid a Bull Trap
Below are several tips on how to avoid a bull trap.
The Bottom Line
Investors must be on their guard for potential bull traps – and do everything they can to not only avoid falling into them but minimize losses should they get caught.
The best advice is not to get carried away by the first sign of a reversal in fortunes. Take the time to research why this may have happened and consider stop-loss tools to cap the potential downside.
