A bull trap makes it seem like a stock is rebounding, but ultimately it turns out to be a short-lived rise. Bull traps are often associated with short-term rises during a market downturn (a.k.a a dead cat bounce) but they can also occur during an uptrend a plateau.
Investing in the stock market means dealing with daily market volatility. The market can make unforeseeable moves, one of which is known as a bull trap. A bull trap occurs when a stock that appears to be moving in an upward direction suddenly reverses course.
Unfortunately, a bull trap can result in investors losing money, especially those who are actively trading and trying to time the market. Keep reading to learn what a bull trap is, how you can spot one, and how to avoid losing money.
What is a bull trap?
A bull trap occurs when a stock that has been trending downward reverses course and starts to increase in price. This price increase leads investors to believe that the downward trend is over and the stock is rebounding. However, it turns out to be a trap, and the stock price again quickly starts dropping.
Bull trap vs. dead cat bounce
A bull trap can is similar to a dead cat bounce and some traders use both terms interchangeably. (The term may sound a little weird, but it comes from a phrase by Raymond DeVoe Jr., “Even a dead cat will bounce.”) However, there are not exactly the same.
Strictly speaking, a dead cat bounce is a type of bull trap. Both terms describe a false signal to investors that prices will continue to rise, but a dead cat bounce always happens during a downtrend. In contrast, a bull trap can happen during an uptrend, a downtrend, or a plateau.
How does this trap work?
Volatility is a fact of life when it comes to the stock market, and there will be times when an individual stock (or the market as a whole) trends downward in price for an extended period of time. Often, the price eventually bounces back. In a bull trap, however, investors are fooled into thinking the stock price is bouncing back when it isn’t.
When a bull trap happens, the price of a stock starts rising, giving investors the impression that the tides have turned and the price will continue to increase. As a result, investors buy the stock, hoping to be on the ground floor of the next price surge, only to have the price fall once again.
Bull traps are most harmful to traders who are taking a bullish position on the stock, hoping to profit from a price increase.
What causes a bull trap?
Bull traps can happen for a variety of reasons. It could be that after a long price decline, bullish investors feel optimistic about the stock’s future and start buying. The buying pushes the price up, but it’s not a long-term change.
Another possible cause of a bull trap is when short sellers are buying back their shares. When someone sells a stock short, they borrow shares to sell from their brokerage firm. They believe the stock price will decrease and they’ll later be able to repurchase their shares for less money and pocket the rest as profit. After the price declines and the short sellers eventually buy back their shares, the market activity can temporarily push the stock price up to cause a bull trap.
Finally, a bull trap may happen because investors who held the stock during the downturn quickly take advantage of the price spike to sell their shares. The increased selling causes the stock’s price to drop again.
How do you trade during a bull trap?
Bull trap examples
As we mentioned, a bull trap can apply to an individual stock or even the entire market, in the case of a bull market. One of the most well-known examples of a bull trap happened in early 2008. In late 2007 and early 2008, the S&P 500 lost about 10% of its value. However, it was followed by about two months of growth, which indicated the market was rebounding.
As you probably know, the market didn’t recover in early 2008. The rebound turned out to be temporary—by June, the market was experiencing major losses again. In fact, by March 2009, the S&P 500 reached its lowest point since 1996, falling more than 50% below its May 2008 level.
The short rebound in early 2008 turned out to be a bull trap. Investors hoped the market had reached its lowest level and would continue to rise, but that wasn’t the case.
What is a bull trap in crypto?
A bull trap for cryptocurrency means the same thing it does for stocks. It occurs when a particular cryptocurrency that’s been on a declining trend appears to be making a rally, but then reverses course again and resumes its price decline.
Bull vs. bear trap
A bear trap is another term to describe a price movement in the market that tricks or “traps” investors. When a bear trap occurs, a stock that has been trending upward begins to reverse course and decline in value. Just like with a bull trap, the new trend is temporary, and it’s not long before the stock once again changes direction and begins to increase in value again.
Unlike bull traps, which harm investors trying to profit from price increases, bear traps harm those trying to profit from a price decline. As we discussed earlier, a bear trap would be a disadvantage to traders trying to short sell a stock.
Signs of a bull trap
Unfortunately, a bull trap can entice an investor to buy a stock because they think it’s beginning to rally. However, the stock price ultimately falls again, causing the trader to lose money. Luckily, there are some ways to spot a bull trap and avoid buying during one.
- Trading volume. First, pay attention to trading volume. If a stock’s price has increased, but the trading volume hasn’t, it could be a sign that the stock’s rebound is only temporary. In that case, give the stock some more time to see if the trend continues and if volume does, in fact, pick up.
- Speed of stock price increase. Another way to spot a bull trap is to pay attention to how quickly the stock’s price is rising. Often stocks that are on the rebound bounce back quickly. If a stock has been steadily or quickly declining and then has only a small increase, it doesn’t have much momentum, and it could be a sign that the increase isn’t here to stay.
- Market analysis tools. To spot a bull trap for a particular stock, it’s helpful to use fundamental and technical analysis tools to understand the stock’s past trends. While past performance isn’t necessarily an indicator of future results, it can give you a greater understanding of that particular stock’s ups and downs.
How to avoid a bull trap
Unfortunately, there’s nothing an individual investor can do to prevent a bull trap.
Bull traps are most harmful to day traders who try to time the market and use its volatility to their advantage. Someone with that investment strategy might buy a stock that’s on the rebound so they can sell their shares in a few months when the stock has fully bounced back. But since a bull trap means the stock eventually loses value again, the trader loses money.
One way to insulate yourself from the effects of a bull trap is to focus on the big picture. Rather than trying to time the market, you can follow a long-term strategy where you contribute to an investment account over many years to take advantage of growth. Instead of buying individual stocks, build a diversified portfolio of mutual funds or exchange-traded funds.
If you have a higher risk tolerance and want to actively trade, but still want to insulate yourself from the effects of a bull trap, you can use a stop-loss order. This type of order instructs your broker to sell your shares when the stock drops to a certain level. While it doesn’t prevent you from losing money altogether, it can help to limit your losses.
- A bull trap occurs when a stock that has been trending downward begins to rally, but after a brief time reverses course once again and starts dropping in price. When entire markets shows this trend, these are called bull markets.
- This trap can cause investors to lose money when they purchased a stock that appeared to be rebounding, since their shares ultimately lose value.
- The opposite of a bull trap is a bear trap, which is when a stock that’s trending upward starts to decline, but quickly rebounds to start increasing in price again.
- Investors can avoid the negative effects of a bull trap by taking a long-term investment strategy rather than trying to time the market.
View Article Sources
- Understanding Common Investments: Stock — New York Investor Protection Bureau Resource Center
- The Basics of Investing In Stocks — Washington State Department of Financial Institutions
- How To Invest In The Stock Market: 8 Basic Concepts — SuperMoney
- Best Online Brokers for Stock Trading in 2022 — SuperMoney
- Best Stock Trading Apps in 2022 — SuperMoney
- Brokerages: Reviews & Comparisons — SuperMoney