By Nathan Ferguson
A bull trap is basically an unfortunate circumstance in which a trader in the market invests either lightly or heavily into an asset thinking that its price valuation will keep on rallying with the passage of time, however the opposite occurs, as the asset’s price valuation plunges after experiencing a local high record.
Bull Traps are known to be watched out for, especially when the market becomes unpredictable, as many uncertain sources are passing on fake guidance and information in terms of a single or multiple assets. Distribution of misinformation is quite common and must be carefully watched out, regardless of the original intend it was initially pushed to be distributed for.
The term “trap” in bull trap mainly refers to inexperienced traders who are tricked into thinking that a plunging asset’s valuation will continue to grow and will keep being bullish about it, making them perform an investment into the asset, only to see that their investment has gone to waste. This can either result in minimal or high level of loss, depending upon how much the investor had played into the falling asset.
Fortunately, if traders can successfully manage to identify a potential bull trap, they should either cancel the trading activity or reach a short position. In order to sustain oneself from being carried away by certain emotions, stop-loss orders can be quite beneficial in these types of situations, in case of rapid market activity.
Highlighting a bull trap can sometimes become quite a challenging work, so the optimal method to dodge bull traps is to figure out clues and signs like low volume breakouts beforehand. More on this below.
Bull Trap Functionality in Finance
Bull traps can be quite fatal and can result in massively unfortunate situations for those who are unable to identify them and invest during a time of uncertainty. For example, a trade is looking into statistical data from sources about an asset that is experiencing a fall. With the passage of time, the price valuation of that asset manages to grab onto a level, where it begins to strengthen indirectly. This is known as a “range”.
At this point, the bullish and the bearish players in the market start to compete, as both sides shift their focus towards control of the price valuation. The bearish players work to help the price fall to record lows, while the bullish players commit to bring the price valuation to experience record highs.
At an unspecified time, a crash from the range occurs, with the bearish players claiming victory, leading to the record low, however just when the plunge is about to happen, the bullish players deliver a counter blow and strive towards bringing the price valuation to a record high.
When traders are notified of such a bullish trend, they decide to start investing, believing that the decline of the price has finally reached a climax. Turns out that the trend was only present for a limited amount of time and the price valuation continues to fall rapidly, resulting in massive amounts of financial loss for the investors who blindly followed the trend.
Bull Traps in the Crypto Space
Popularly called as “dead cat bounce”, bull traps are sort of common in the crypto space because of rapid recuperation of prices.
Just like other financial spaces, Bull traps function similarly in the cryptocurrency space. For Example, an altcoin is experiencing a rise in value in the past week, bringing a sort of deceiving hope of a bullish trend, so traders take the opportunity to invest into the altcoin, be patient till the price reaches a high and then trade it, in hopes of gaining an undisclosed amount of profit.
Nonetheless, the trader is basically stuck in a position where there is a huge uncertainty in the price valuation of the altcoin, thinking that the investment was made on a profitable price. But as time passes, the bull trap starts to show itself, and the price valuation of the altcoins falls, resulting in a plunging trend, overall leading to a loss in investment.
Investing into the cryptocurrency sector requires some basic knowledge about recurring order types. There are multiple types of these orders and learning about them can be advantageous, as it will make it quite trivial to explore order types and options present on different cryptocurrency exchanges.
Psychological Aspects of Bull Traps
Bullish players put their best efforts to achieve better price trends, which is great for them, however, as said before, bearish players also exist, so bearish situations in the market can happen at any time.
With a bearish market, the bulls are clenched onto a “bear trap”, and are forced to settle their case, witnessing losses. Because of this one-sided type of mentality, traders who focus on investing during bullish markets can often be strangled into the trap of investing at highs and then trading at lows.
Many professionals around the world have suggested traders to keep a mindset that deals with both bullish and bearish sides, to become successful in the overall market, leading to a profitable position.
Usage of Bull Traps
Bull Traps are commonly utilized by entities in the market such as day traders and investors that focus on long-term value. The main intention behind it is to gain a competitive advantage over inexperienced traders in the market who are either unaware of this, or easily fall for the trap.
In terms of day traders, bull traps can give them a chance to scant securities, with it being able to return to its previously recorded high. Following that, the downward graph of the price valuation recommences, eventually pouring profits into the pockets of these traders.
For investors focusing on long-term, the situation is a bit different, as bull traps provide them a chance to purchase security at a low rate, after continuing its downward trend post rally. The investors then store those securities and wait till the next upward trend shows up, which they can then sell off those purchased securities and sell them off for profits.
Foundation of Bull Traps
There are several reasons for the development of a bull trap. One of the common reasons to the foundation of bull traps includes the scarcity of number of purchases with the price valuation trending back towards a recorded high. Low levels of purchase highlight that many are not attracted to the securities which are cheaper, and the bullish players are not capable to propel the price valuation to a higher number.
Furthermore, another one of the commons reasons for bull traps is a fallacious breakout that originally develops due to a consolidation pattern. The price valuation suddenly erupts forward, crossing the range topside, however it then immediately plunges and continuous a steady downward trend yet again.
Highlighting a Bull Trap
Exposing a bull and bear traps can be quite tricky and challenging, however there are multiple ways to detect their presence in the market.
Relative Strength Index (RSI)
Relative Strength Indicator (RSI) is basically a type of indicator that highlights momentum and is utilized during technical analysis. RSI determines the change and magnitude of price shifts regarding securities, to determine whether that price shift is overvalued or undervalued.
Not only does RSI determine the price shifts, but it also tell if securities are going to experience a major reversal in price trend, letting traders know when it is time to purchase or when to sell. According to studies, the greater the RSI, the more chance there is for a bull or bear trap to be highlighted. An RSI value of 70 or above usually tells that the security is overbought and a value of 30 or below tells that the security has been oversold.
There is a specific formula to calculate the relative strength index, which will help to have a clear vision on where an asset stands in terms of its purchase numbers.
Formula -> RSI = 100 – (100 / 1 + (average gains during closing/average loss during closing))
This mathematical formula for RSI usually involves around two weeks of records, but it is possible to consider further or below that time frame. The period however is insignificant, as it has no presence in the formula mentioned above.
Indication of a bull trap is determined if the RSI value is large, giving hints about the developing pressure surrounding sales numbers. Traders are mostly focused on securing their profits and are most likely to wrap up the trade at any given time. Following that, the initial breakout upward trend is not always a sign of an increase in price valuation.
Deficiency of Volume Numbers
If a market is genuinely breaking out topside, it means that a significant surge in volume is expected, as more and more traders are purchasing the security in its rallying state.
If in the case where there is minimal surge in volume numbers during a breakout, it should mean that traders are not attracted to that security because of its unusual pricing, as they think that its rally might not be profitable for them.
If the price manages to surge, despite of little increases, this may highlight that bots and retail traders are battling it out for a respectable position in the market.
Scarcity of Driving Power
A stock sees a keen drop or gap-down, and then manages to make a smooth recovery, this highlights a bull trap. The market usually traverses around in a circular motion, but when it manages to set foot on the top, it is mainly a time of consolidation, with both bullish and bearish players competing each other for significant control and power over the market.
This scarcity in the driving power can be highlighted as an initial indicator towards a market that might experience a major reversal.
Missing Trend Breakage
A fall in price valuation is usually highlighted by a series of either falling lows or falling highs. Advances are not the only situations where the price valuation of a stock may experience a significant shift. A downtrend will persist until the price valuation surge will not go beyond the recorded falling high.
A very and common recurring oversight done by inexperienced traders is not focusing on confirmation, resulting in them being stuck in the grasp of bull traps. Traders should be aware that if the current high is not able to cross the recorded high, then it obviously indicates a major downward trend.
This type of situation is mostly called “no man’s land” and is a position that is clearly not suitable for performing purchases unless there is an important and genuine motive behind it. While a portion of traders might not see this as a good sign, however majority of them are advised to stand by until a confirmation is received, letting them purchase at good prices. What is not advised is to be impatient and then suffer the consequences that a trap carries.
Re-testing Resistance Levels
One of the primary highlights of an upcoming bull trap is a strong momentum that is bullish, and which also persists for a longer time frame, however it quickly responds to a special resistance zone
A way to figure out if purchasers are pouring their resources is whenever a stock manages to build its ground towards a major upward trend, having minimal pressure that is bear. But when a resistance level starts to show itself, they are not confident enough to pull through, leading to a reversal of price prior to experiencing an even higher upward trend.
Skeptically Massive Bullish Candlestick
Considering the closure of a trap, a massively bullish candlestick develops, dominating the other candlesticks before it. This is one indication that is has quite a significant role. In order to gain power over the market, this is mainly the final push of bullish players in advance, as the reversal of price valuation approaches.
Behind this lies many motivations and intentions which are to be highlighted. Firstly, experienced and powerful entities in the market are forcing the price to reach a high, to lure in experienced and innocent traders who are looking to purchase.
Secondly, fresh investors start their purchasing once more, because they think that a breakout is either imminent or is currently in progress.
Lastly, to promote the acceptance of sell limit orders that cross the resistance zone, dealers allow investors to gain power in the market for a limited time.
Range Development
Mainly being highlighted as a concluding indication of an approaching bull trap is the development of range-based patterns that occur on resistance levels. When a price valuation swings inside of a particular range, it means that it is swinging in between of a support and a resistance level.
Some examples of trap patterns include the Rejected Double-top that consists of two protruding candlesticks representing a double top pattern, but the second candlestick highlights a large rejection upside. The rejection indicates that even if the investors seek to push prices higher, the sellers quickly enter and overwhelm the investors, leading to a bull trap.
The Bearish engulfing is one that includes an engulfing pattern that develops after a bull trap pattern, it highlights the coming of a strong bearish movement. Several of these bearish candlesticks can contribute towards a bull trap patten, enabling traders to trivially select them from critical sections.
And lastly, the failed re-test pattern which occurs post to the breakage of the resistance zone, however when the price returns for a re-test, it fails and crashes, losing momentum and leading towards a bull trap pattern instead.
This range however, focusing on the top end, is not always accurate in the case of the market experiencing minimal higher highs. Despite the inaccurate range, a bull trap slowly starts to show itself, in conjunction with the development of a huge bullish candlestick that dissolves independently from the range.
Experienced traders, patiently stand by till the price recovers and then proceed to re-test resistance zones. The price might drop for the re-test, but rather than recovering back, it develops a range, leading to high rejections and then deforming at a rapid pace, overall contributing towards a major bull trap.
Conclusion
These are the major features that show the proper indications of an upcoming or occurring bull trap. It is important that traders must know about these sorts of traps in the market, especially when they are willing to invest their hard-earned finances to gain benefits.
Being aware of such situations and traps is probably the most beneficial way that traders can work around to be successful, not only in the traditional financial market, but also the cryptocurrency space.
Since these sorts of traps are also associated with the cryptocurrency sector, it is important that investors should be more vigilant and cautious, as cryptocurrencies have almost equally important value, especially in this modern day of age.