When thinking about fake buying signals that “trap” traders in losing positions, bull traps are usually the first thing that comes to a trader’s mind.
Bull traps can be very frustrating as they seemingly provide attractive buying signals, only for the price to immediately and abruptly reverse in the opposite direction.
Discover what there is to know about bull traps, how to avoid them, and how to make money trading them.
Bull Traps Explained
Bull traps are false buying signals that “trap” investors and traders who acted based on those signals. Bull traps form when a market breaks above a well-defined resistance level, sending the signal that prices have further upside potential, only to immediately reverse and break below a support level.
The initial buying signal catches many investors and traders who initiated long positions off guard when the market reverses, leading to large and unexpected losses.
The opposite of a bull trap is a bear trap. Bear traps form when the market breaks below an important support level, followed by an immediate and abrupt reversal.
Both bull and bear traps can be very frustrating for traders who base their trading decisions on breakouts. Fortunately, there are ways to avoid bull traps and even to make money with them, which will be explained further below.
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Why Do Bull Traps Happen
Bull traps can happen for a variety of reasons. When the market breaks above an important resistance level, bulls who have been already long may decide to close their positions, leading to an increase of supply and selling pressure in the market.
Traders who are bearish on a market may think that the breakout is not sustainable and that the current price is too high and the market overbought, which leads to a wave of selling orders and an abrupt reversal of the uptrend. Traders who are bearish on upside breakouts base their trading decisions mostly on market fundamentals, which is an effective way to avoid a bull trap.
As selling pressure builds up and the market moves lower, stop-loss orders of traders who entered with long positions might get triggered, accelerating the down-move even further. As a result, the market could break below an important support level, form a fresh lower low, and form a bearish trend reversal signal.
Liquidity can also be a reason why bull traps form. Low liquidity in the market usually leads to higher volatility. When liquidity dries up, even a relatively small buying order could lead to large upside movements as there are not enough sellers to absorb the sudden spike in demand. As a result, a market could break above a resistance level but immediately reverse as liquidity picks up and sellers start joining the market again.
How to Avoid Bull Traps
There are many ways to identify and avoid a bull trap. Here, we’ll explain some of the most effective ones.
Volume: A key difference between a bull trap and a valid upside breakout is trading volume. If a breakout occurs on a low volume, chances are that you’re dealing with a bull trap. Low volume usually occurs during times of low liquidity, meaning that there are probably not enough sellers to absorb the breakout until liquidity picks up again.
Indecisive candlesticks: Another important sign of a bull trap is indecisive candlesticks, such as dojis or spinning tops. If you identify an indecisive candlestick pattern right after an upside breakout, resist the temptation to open a long position. Valid breakouts are usually followed by strong upside movements and large trading volume. If the market forms a strong bullish candlestick right after the breakout, the breakout could be real and the market could continue to trade higher.
Pullbacks: Once an upside breakout occurs, you don’t have to immediately open a long position. Instead, try waiting for a pullback to validate the breakout. Pullbacks form when the market reverses and faces buying pressure right at the broken resistance level, signalling that new buyers are joining the market and pushing the price higher. If the pullback fails to find support at the previously broken resistance level, chances are that we’re dealing with a bull trap.
Multiple retests of a resistance level: Bull traps can often be anticipated by analysing the previous price behaviour. If a major resistance level gets retested over and over again, this signals that buyers don’t have enough strength to push the price above the resistance level. In other words, any push above the resistance should be taken with a grain of salt as it could lead to a bull trap.
Market correlations: In addition to technical levels, savvy traders also pay attention to cross-market correlations which can help them avoid bull traps. Cross-market correlations are correlations between dependent markets, such as interest rates and bonds, gold and the US dollar, or commodity currencies and the price of commodities.
Late entries: It’s not enough to only pick the direction of the market right, but also to have a good entry point. Late entries into upside breakouts increase the chance of losses if the breakout proves to be a bull trap. Avoid late entries at any cost, there’s always another trading opportunity just around the corner.
Trading in the Direction of Fundamentals
Traders who trade predominantly on technical levels will have a harder time to avoid bull traps than traders who also combine fundamentals in their analysis. In their early formation, bull traps do look like valid and powerful buying signals, especially to traders who trade upside and downside breakouts.
However, traders who also follow market fundamentals may know in advance that an upside rally in certain markets doesn’t make any sense. If almost all fundamentals point to further weakness in the market, fundamental traders may take advantage of bull traps and actually trade in the opposite direction of the bull trap by opening a sell order.
Fundamental data that can help you get a clearer picture of future market behaviour include:
- Earnings reports
- Monetary policies of central banks
- Economic growth forecasts
- Inflation rates
- Interest rates
- Labor market statistics
Try to stay up to date on those key fundamentals to determine whether an upside breakout could turn into a bull trap.
Example of a Bull Trap
Bull traps form in all financial markets. The following example shows several bull traps in the EUR/USD pair on the 1-hour timeframe. Let’s go through the example step by step and see whether we could avoid getting caught by the bull trap.
Line number (1) shows a strong resistance level formed on the 1-hour chart. The two arrows numbered with (2) show fake upside breakouts or bull traps that could have led to large losses for traders who opened a long position.
If you look closer at the previous price-action, you can notice multiple retests of the resistance level. This is the first sign that buyers don’t have enough power to break above that resistance, and that any upside breakout could actually prove to be a fake breakout or bull trap.
The multiple indecisive candlesticks formed around the resistance level are another sign that the market lacks direction. Notice the spinning tops, dojis, and pinbar patterns that have formed right at the resistance level.
All attempts by the pair to break above the resistance level were short-lived. The breakouts lack confirmation, and not a single candlestick has managed to close above the resistance. This is a clear sign to avoid opening a buy order, at least until we see a clear upside breakout followed by a well-defined pullback to the broken resistance.
Finally, the pair moved decisively lower with a strong bearish candlestick at point (3), providing traders with a selling opportunity by placing a stop-loss at line number (4). The pair moved almost 100 pips lower in the coming hours.
How to Make Money with Bull Traps
Although most traders could be very frustrated about bull traps, they’re one of my favorite technical signals to trade. Bull traps, or fake breakouts, are powerful signals to open a trade in the opposite direction of the breakout.
If you see a bull trap and the price reverses, it’s time to open a sell order. Conversely, if you see a bear trap and the price reverses to the upside, it’s a signal for a buy order.
Here’re a few tips on how to trade bull traps.
Wait for a candlestick confirmation – Once you identify a bull trap, don’t enter into a sell immediately. Instead, wait for a candlestick confirmation, which includes anything from a bearish engulfing pattern, evening star pattern, or bearish marubozu pattern.
Waiting for confirmation is always a good idea before placing a trade, whether you’re trading bull traps or not.
Watch out for divergences – Sudden spikes and upside breakouts are usually accompanied by strong bearish divergences between the price and an oscillator, such as the RSI.
A bearish divergence forms when the price makes a fresh higher high (such as in a bull trap), but the indicator fails to follow and forms a lower high instead. This is a strong sell signal, which combined with other signals can lead to huge profits when trading bull traps.
Check cross-market correlations – Again, if a correlated market doesn’t replicate the upside breakout of the market you’re trading, it’s likely a bull trap. Cross-market correlations can be used to confirm a selling opportunity and trade in the opposite direction of the bull trap.
Avoid trading when liquidity is low – Bull traps often form when liquidity is thin. Even though it might be tempting to open a short after you notice a bull trap, lower liquidity means higher trading costs and erratic price movements.
You’ll be better off trading bull traps during times of higher liquidity, such as during the NYSE open-market hours or the NY-London session overlap in the forex market.
Identify trend reversals – Last but not least, bull traps often lead to large and sustained price-movements in the opposite direction and sometimes even trend reversals. Waiting for a clear sign of a trend reversal could significantly increase your success rate of trading bull traps.
Wait for a break below an important support level or the formation of a fresh lower low before opening a sell order. Although this means leaving some of the profits on the table, there will be a higher probability that you’re on the right side of the market.
Bull traps refer to fake upside breakouts after which the price makes a sudden and unexpected reversal, breaking below a well-established support level. Bull traps can be quite frustrating, especially if your strategy involves trading upside and downside breakouts, but savvy traders can also use them to their advantage.
Bull traps are some of the most reliable reversal patterns in the market. However, bear in mind to always use stop-losses and to wait for multiple confirmation signals before opening a trade in the opposite direction of the breakout.