What is a bull trap? A bull trap tricks investors into thinking a stock price decline is finished and that it’s a good time to buy. Learn how to avoid being in one.
Basketball has the head fake. Football fans are surely familiar with the flea flicker and Statue of Liberty plays. Markets have their own versions of ruses (what football announcers might call “trickeration”). One is the bull trap, also called the suckers’ rally.
So, what is a bull trap? A bull trap fools some traders into thinking a market or an individual stock price is done falling and that it’s a good time to buy. But then it turns out it’s not a good time, because the price soon resumes its descent, catching buyers in a money-losing trap. In many ways, it’s the opposite of a “bear trap,” which can fool traders into selling out too soon in the midst of a bull market.
A grasp of how bull and bear traps work became essential on June 14, 2022 when the S&P 500 Index (SPX) slid into its first bear market since March 2020, the month COVID-19 shutdowns began.
Bear markets and steep, broad-based sell-offs are often followed by quick, sharp rallies. So how and when can investors know if price upswings are for real and have legs—or are just a mirage? Here are some basics.
Bull traps can emerge after a market downturn appears to have been exhausted. In the wake of steep declines, there’s often clamoring among investors to grab an early seat for the ride back up, get in at what appears to be a bargain price, and/or pick a bottom.
These initial buying spurts may push prices above certain chart levels, and these “breakouts” can trigger more buying. But such breakouts may actually be false signals, and the price soon resumes a downward path.
The S&P 500’s (SPX) retreat from all-time highs in January 2022 suggests investors had witnessed a bull trap weeks before this article’s publication date. The chart below tells the story.
Before the first downward leg of the slump in early January 2022, SPX was at a level of 4,800. Despite significant volatility along the way, the index fought its way up from the 4,100 level near late February to around 4,650 by the start of April.
Within this time frame, that pinnacle turned out to be the end of the diving board. Amid rising geopolitical tensions and inflation worries, bullish buyers would take a nearly 20% ride down to bear territory as of mid-June 2022, with more volatility to come (see Figure 1).
The thinkorswim platform has hundreds of technical indicators and studies to choose from, plus dozens of drawing tools so you can create your own patterns. Not sure where to start? TD Ameritrade clients have free access to articles, videos, webcasts, and a fully immersive curriculum covering all elements of technical analysis.
“Confirmation is an important element to establishing a new, long-term trend,” said James Boyd, Education Coach at TD Ameritrade. “Some market pros look for confirmation through a few key indicators, including trading volume.”
Boyd explained that if price is rising but fewer shares than average are changing hands, that may suggest a lack of broad conviction among buyers, meaning the rally could eventually fizzle. He suggested adding a volume function to a daily stock price chart to see how recent trading compares over the past year or so.
Keeping a close eye on longer-term price charts, tracking simple moving averages and other technical indicators, and knowing where key support and resistance levels are can help investors spot bull traps. Breakout points vary depending on time horizons and other factors.
For example, surpassing the 20-day moving average may spur stepped-up buying, but is it a true breakout? Some market professionals prefer to see a move above the 50-day or 200-day moving average before they consider it confirmation of a long-term trend. Some traders take it a step further and look for confirmation from a technical oscillator such as the Relative Strength Index (RSI), which helps identify so-called overbought/oversold conditions (see figure 2).
Candlestick charts are another handy technical tool to help identify price patterns. Some candlestick chart types are specifically designed to help spot bullish or bearish movement and whether a trend looks to be continuing or reversing (see Figure 3).
FIGURE 3: LIGHT ’EM UP. Want to use candlesticks to help you spot the bear? Fire up the thinkorswim platform. Under the Charts tab, select Studies > Add Studies > Bearish Only Candlestick Patterns. For illustrative purposes only. Past performance does not guarantee future results.
But remember that technical indicators are just that—indicators—not guarantees that a price will move a certain way. Typically, with technical analysis, you don’t know for sure whether it’s a true reversal or a bull (or bear) trap until after the fact. That’s why many chart watchers suggest charting multiple time frames to add context to your views.
Bull traps are just one of many ways the markets can fake out investors and traders, and the reasons why they happen to have a lot to do with what’s going on inside our heads.
Bull markets can lead to bad habits for investors and traders, according to Dr. Kenneth Reid, founder of DayTradingPsychology.com. These habits may not be harmful as long as bull conditions last, but they can have major negative implications when a bear market returns.
Bad habits include “chasing” market leaders as a bull market evolves. Hedge funds and other types of investors may be piling in and out, and dramatic price movement catches everyone’s eye. Chasers get conditioned to expect continuation of strong moves up, but that’s a trap during bear markets. Investors who are used to trading in a bull market can fall into the trap of buying high and selling low due to a “unidirectional mentality.”
“Although bull markets offer plenty of opportunities to make money, they don’t necessarily help you become a better trader,” Reid said. He recommended investors and traders develop a “bidirectional mentality” to help put them in a position to understand in both bull and bear markets.
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