Real Rally or Ruse? Tips to Avoid a Bull Trap

When trying to determine a good time to buy a stock, a trader might look for signs that the market is ready to resume an upward trend. When it looks like a stock price is about to rebound, or the market is headed higher, a trader might be tempted to buy in. But if the rally doesn't materialize, this move is sometimes called a "bull trap."

A bull trap fools some traders into thinking a market or individual stock 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 trade. In many ways, it's the opposite of a "bear trap," which can fool traders into selling too soon in the midst of a bull market.

Bull traps can emerge after a market downturn appears to have been exhausted. In the wake of steep declines, some traders want to buy at a bargain price or enter trades just before the assumed recovery.

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 may soon resume a downward path.

The S&P 500^® index's (SPX) retreat from all-time highs in January 2022 suggested traders had witnessed a bull trap.

Before the first downward leg of the slump in early January 2022, the SPX was at a level of 4,800 (see image below). 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.

Before entering a trade during what looks like a potential bull rally, it might make sense for traders to use technical tools like volume, momentum indicators, and candlestick charts to look for confirmation.

Some traders start with volume. If the stock 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 end quicker than expected. Adding a volume function to a daily stock chart to see how recent trading compares over the past year could provide insight.

Another technical tool that might help identify a potential bull trap includes using a simple moving average (SMA) indicator and knowing where key support and resistance levels are.

For example, surpassing the 20-day SMA might indicate stepped-up buying, but it might not be a true breakout. Some traders prefer to see a move above the 50-day or 200-day SMA before considering it confirmation of a long-term trend. Other traders take it a step further and look for confirmation from a technical oscillator like the Relative Strength Index (RSI), which helps identify potential overbought or oversold conditions (see image below).

Finally, candlestick charts help trader's identify potential price patterns. Some candlestick chart types are specifically designed to help spot bullish or bearish movement and whether a trend could be continuing or reversing.

In thinkorswim, traders can add candlestick patterns to identify or confirm a potential trend by selecting Studies > Add Studies > Bearish Only Candlestick Patterns under the Charts tab, as seen below.

Technical indicators can potentially help traders identify a bull trap, but they're no guarantee that a price will move a certain way. Typically, with technical analysis, a trader doesn't know for sure whether it's a true reversal or a bull (or bear) trap until after the fact. Some chart watchers suggest charting multiple time frames to add context. With multiple time frames, it's possible to compare indicators over varying time periods to get a better idea of historical and potential performance.

Bull traps are just one way the markets can fake out traders, and the reason why they happen to have a lot to do with the trader's psychology.

Bad psychological 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. Traders 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." 

By developing a "bidirectional mentality," traders can potentially approach a trade better prepared to deal with both a bull and a bear market.