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What is a bull trap in trading?

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“Bull trap” or “bullish reversal” means a change in the trend at the highs of a particular trading instrument.

Every trader can encounter a situation on the financial market when quotes overcome the resistance level, after which active growth continues for some time. However, soon the instrument reverses and moves in the opposite direction, knocking out stop losses. This false breakout, where traders make the mistake of opening buy positions, is called a bull trap.

The article examines in detail the reasons for the emergence of the pattern, as well as options for how not to fall a victim of this trap. By learning the types of bullish reversal, you will save your capital and increase it. LiteFinance will help you with this.

The article covers the following subjects:

What is a bull trap and why does it happen?

Bull Trap in trading is a pattern that is represented by a false impulse breakdown of resistance amid declining volumes. The trader needs to spot this bearish formation in a bullish market. The pattern appears because buyers do not have the strength for further growth. Mostly this happens due to profit taking by market participants. In addition, pressure on the price is exerted by the opening of short positions by sellers who do not want to miss the opportunity to earn by taking advantage of the situation, and return the quotes below the resistance level.

Why below the resistance? The answer is simple. Because stop-losses of the buyers are placed in this zone. Their triggering serves as fuel for further decline.

Therefore, in order to avoid falling into the trap, before opening a long position, you need to pay attention to additional indicators that confirm a breakout and emphasize the growing volume of purchases. You can analyze candlestick patterns and identify divergence with the following indicators:

One of the key features that these technical indicators have in common is that they show the appearance of bullish and bearish divergences.

Divergence in the financial markets means that the price movement in the chart does not match the technical indicators. In simple words, the price is growing in the chart, while the indicators are declining, and vice versa.

Examples of bull trap

In the daily chart of Apple Inc. you can see a typical bull trap, which is characterized by the following features:

  1. The formation of a bearish divergence in a bullish trend on the RSI indicator, which is an early signal for a price reversal at the top.

  2. A drop in trading volumes at the breakout of the resistance level, which indicates a decrease in consumer demand and profit-taking by participants.

  3. Formation of bearish Engulfing and Dark Cloud Cover patterns at local highs, which signal the opening of short sales by bears.

Another example of a bullish reversal can be seen below in the daily GBP/USD chart. In the current situation, the following characteristic features served as signals of emerging danger for the buyers:

  1. The MACD indicator warned in advance about the imminent price reversal, forming a bearish divergence.

  2. The volumes began to decrease, just like in the first example, while the quotes grew. This should alert traders, as this is a warning about the bears seizing the initiative.

  3. The confirmation signal was the emergence of the bearish Hanging Man pattern, which is a reversal candlestick formation at the top.

Paying attention to the above factors would allow market participants not only to avoid falling into the bull trap, but also to increase their capital by opening a short position in the instrument above the indicated resistance level.

We can see a great example of a bull trap in the daily BTC/USD chart. The picture below similarly shows a bullish rally followed by strong resistance from buyers. Here, the bulls were twice driven into a trap after an impulse breakout of resistance, however, in both cases, quotes returned back. The following factors contributed to this:

  1. The formation of a bearish divergence on the Stochastic indicator.

  2. Consistent decline in trading volumes.

  3. Formation of a bearish Engulfing candlestick pattern, which is a reversal pattern at the top.

How to identify a bull trap – Bull trap technical analysis

Spotting a bull trap is easy if you know how to do it. Be sure to use one or more of the above indicators and monitor the trading volume on a particular financial instrument. In addition, it would be great to study the classic patterns of reversal at the top within candlestick analysis, for example, “bearish engulfing”, “hanging man”, “evening star”, and “dark cloud cover”. The combination of indicator and candlestick analysis will help you avoid falling into a bull trap, as well as save and increase capital.

Below we will give a step-by-step instruction for identifying a bullish reversal using the BTC/USD chart as an example.

1. Let’s identify the bearish divergence in the chart using the technical analysis indicators MACD, RSI, and Stoch.

 

In the BTC/USD chart, you can see that the MACD indicator showed a divergence earlier than the RSI and Stoch. Therefore, traders had the opportunity to prepare in advance and avoid falling into the first trap, locking in their positions either with profit or at breakeven.

However,slightly later the RSI and Stoch indicators warned of the impending second bull trap, which was accompanied by a second impulse breakout of the resistance level amid the declining volumes.

2. Speaking of volumes. The second important feature is market conditions. An analysis of supply and demand, as well as an estimate of trading volume, will also help avoid this tricky trap.

3. A key component in identifying a bullish reversal is the analysis of candlestick patterns.

In the current situation, we can see that the bearish engulfing patterns have formed at new highs after the bullish dynamics. Moreover, the patterns were formed on impulse breakouts of the resistance level in both the first and second cases.

4. Setting stop-losses.

It is important to remember about risk management when trading on financial markets and to place stop loss orders without fail if you have already opened a position. Even if you fall into such a trap, there will be an opportunity to save capital with small losses.

Combining these actions with consistent and clear analysis will avoid the market trap that many traders and investors lose money on.

Bull trap chart patterns

In this section, we will look at the types of bull trap that can be found in the charts. Let’s study the nuances that should be taken into account when analyzing certain types of this pattern.

Pattern №1 – Springing Double Top

This is one of the traditional patterns where after reaching a certain level, quotes reverse back down. In the AUD/USD chart, at four points at local highs, there was an attempt to raise the price higher, but it wasn’t successful. At the fourth point, a bearish tweezer top pattern was formed. The final confirmation of the trend reversal was the formation of the hanged man pattern. At the fifth point there was an irreversible capitulation of the bulls, from where the price went down.

Pattern №2

After a short period of consolidation, the asset makes a sharp jump up called a “piercing”, forming a tight bar to collect buy orders. However, this is a trick, after which the price goes down. The EUR/JPY chart is proof of this. In addition, a strong reversal signal formed next – the hanging man pattern.

Why should you avoid bull traps and how to do it?

Avoiding bull traps is essential for at least one major reason: saving your capital. Sometimes this is not easy, because before the trap occurs, the movement is in line with traders’ forecasts and the price is moving in accordance with the trend. So most of the unsuspecting traders are already in a trap.

You probably have a logical question: how do I avoid falling into a bull trap and still make money? Below you will find the ways to avoid these traps.

Method №1

First you need to make sure that this is not a false reversal. Confirm the breakout additionally with the help of various figures or candlestick patterns of trend continuation, such as the “bull flag” or the “three white soldiers”, “three bullish steps”, “separating lines” patterns.

Method №2

The point of this method is to confirm the breakdown with technical analysis indicators. You can use RSI, Stoch, MACD, but this is best confirmed by the continued growth in trading volumes. During a breakout, volumes should at least stay at the same level and continue to rise. If the reverse dynamics develops, it is more likely that a bull trap is being formed with a purpose to collect as many buy orders as possible above the resistance level.

Method №3

Another method to avoid falling into a bull trap is to analyze the close of the daily candle and the length of its shadow. Often on lower timeframes, the price can consolidate above the resistance level, and on the daily one, only the shadow of a candlestick can remain. This means that the bulls did not have enough strength for an impulse breakout and a bull trap is more likely to form, after which the asset will begin to decline.

How to trade bull traps: the best strategies  

Let’s consider the most effective strategies for successful trading with the bull trap pattern. You can use these strategies to avoid falling into this market trap and profit from the situation.

Combination of indicators and candlestick analysis strategy

The point of the strategy is in the name. This method involves a combination of indicator and candlestick analysis.

To be more precise, it uses chart analysis with the RSI, Stoch, MACD indicators and the volume indicator in combination with bearish and bullish candlestick analysis patterns.

The instruction for this strategy will be provided below through the example of the USD/CHF daily chart:

1. First, in the chart, you need to identify the resistance and support levels.

At first glance we see nothing suspicious. There is a quite predictable picture of a bullish trend. A model similar to a bull flag appeared on the left, however, after a breakout upward, the bulls fell into a resistance zone. That is, something prevented the price from moving higher. This was the first sign of a bull trap.

2. Next, using the “Indicators” section, you need to add the “Volumes” indicator to the chart.

After adding Volumes, it became clear that the growth is accompanied by a decrease in trading activity, which is the reason for the deceleration of the bullish trend.

3. The next step is to choose one of the three oscillators.

In this example, let’s take the RSI indicator, which is used by many market participants. Using this indicator, you need to determine how strong the bullish trend is and whether there is a bull trap in it.

The indicator analysis showed that the price is growing in the chart, but decreasing on the RSI, so we have identified a bearish divergence. This is an early signal for a price reversal at the top, and here we can safely say that a bullish reversal has formed.

4. Next, you need to do a candlestick analysis.

It confirmed the transition of the trend from bullish to bearish. A lot of candlestick patterns have formed in the chart, which are reversal patterns at the top. In particular, it is necessary to note the appearance of the bearish engulfing and hanging man patterns, which indicate that there is strong resistance at this level and the bears have activated. Candlesticks with long tails up are called “shooting stars” and similarly emphasize that the bulls are trapped.

If you see a similar situation in a particular financial instrument, before entering the market, make sure in the similar way that this is not a bull trap.

5. Opening a short position.

After the final confirmation of the bull trap pattern, you can open a short position at point 1 or 2. To comply with risk management, it is better to close the first half of the position at the nearest support level. Next, you need to watch for the appearance of bullish reversal patterns in the chart, for example, such as a hammer, an inverted hammer, an engulfing, a piercing, or a morning star. In our case, an inverted hammer first appeared in the chart. The reversal was confirmed by the bullish engulfing pattern, after which it is best to close the rest of the position.

With this approach, you can not only avoid the bull trap, but also make money, and the convenient Litefinance web trading terminal will help you with this.

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Conclusion

In this article, we analyzed in detail the bull trap pattern, its varieties and the reasons this pattern appears. In addition, the article explores in detail the methods of avoiding such traps and presents an earning strategy with the purpose of preserving and increasing your capital.

The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteFinance. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.

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