When a false signal indicating that a declining trend in a stock or index has reversed and is heading upwards then it is called the bull trap. This trap usually happens to occur when a trader or investor buys a stock that is about to break out above a resistance level – a common technical analysis-based strategy. When the most breakouts are preceded by strong moves higher, there are some cases when the stock quickly reverses direction. It is called as bull traps since the traders and investors that bought in are trapped in the trade.
However, you can avoid bull traps by looking for confirmations following a breakout. Let us understand by an example that traders may look for higher than average volume and bullish candlesticks following a breakout to confirm that the price is likely to move higher. A sign of bull trap can be when a breakout that’s proceeded by low volume and indecisive candlesticks – such as a doji star.
Generally, bull traps occur when bulls fail to support a rally past a breakout level, which could be due to a lack of momentum or profit-taking. It is said that the bears may jump on the opportunity to short-sell the stock to send prices back below resistance levels, which can then trigger stop-loss orders from the originally bullish traders.
Probably, one of the best ways to handle bull traps is to try and see the warning signs ahead of time and then exit the trade. In such circumstances, the stop-loss orders can be helpful – especially if the market is moving quickly – to avoid letting emotion drive decision making.
Investors can also avoid a bull trap by waiting for a breakout before purchasing the stock or mitigated losses by setting a tight stop-loss order just below the breakout point.