Bear and Bull Traps – Use ‘Em, Don’t be Abused by ‘Em

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Bear and Bull Traps – Use ‘Em, Don’t be Abused by ‘Em

The price breaks out in the direction you expect, and you jump aboard with a trade. Moments later the breakout has failed and you find yourself in a trade that is rapidly accelerating in the opposite direction. Welcome to bull traps and bear traps; terms used to describe an event where traders are trapped into thinking one thing is about to happen, only to have a bait-and-switched pulled on them. Here’s what bear and bull traps look like, and how to use them instead of being victim to them.

Bear Traps and Bull Traps

Bear and bull traps occur in all markets and on all time frames. I see them when I day trade futures and I see them in the forex market. When London opens in the forex market it is very common to see a bull or bear trap. Typically there is low volatility overnight, and when London opens the price moves outside that range (on one side or the other) only to move back the other way shortly after. Traders looking at the overnight session may view this as a breakout, and it may be, but it also could be a trap.

Figure 1 shows a EURUSD 15 minute chart. The overnight range is marked with horizontal lines, showing the overnight high and low. As London opens (highlighted in yellow) the price just edges above the overnight high.

Since buying on new highs is a common strategy (not one I endorse) it is likely many traders get caught by this type of price move–buying on the new high only to have it quickly move back the other way. This is called a “bull trap” because buyers (also called bulls) are expecting the price to go higher and buying in anticipation; it’s a trap because it didn’t work out.

Figure 1. EURUSD 15 Minute Chart

The price then also breaks the overnight low, by a larger margin, but then it too aggressively moves back the other direction–this traps the bears or sellers, and is therefore called a “bear trap.” This was a particularly sinister day for those buying on new highs or selling on new lows because there is yet another bull trap, as the price rallies above the former high only to quickly reverse. The price then finally settles into a downtrend.

Dealing with Traps

There are several ways to deal with traps. Before getting into them though it is important to point out that bear and bull traps are quite common. Since they are common, it is important to accept that it is likely you’ll be caught in one at some point, and you do have options.

1. The first option is to do nothing. If you have a winning trading plan, losing trades happen. Accept that you may occasionally get stuck in a bear or bull trap and accept it.

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2. Reverse. If you are an active trader, and are comfortable with it, you can “flip” your position. Get out of the trade you’re in and go the other direction. For example, you sell a breakout to the downside, the price moves only slightly lower and then snaps back the other direction. Exit the short or put, and go long or buy a call.

If you can’t exit your position, you may simply be able to “hedge.” For example, if you have a bought a put, you can buy a call once you see the bear trap is occurring. The danger here is that it is possible to end up with two losses instead of just one.

3. Don’t buy breakouts to new highs, or sell breakouts to new lows. This third option involves altering your strategies to avoid trade setups which often result in bull and bear traps. While it is a personal choice–and definitely not the only way to trade– I don’t buy when a new high occurs or sell when a new low occurs. During a downtrend, for example, I sell during pullbacks higher and exit just beyond former lows (basically I am getting out on those traders who are just entering on the new low). In an uptrend, I enter during pullbacks lower and exit the trade usually just beyond a former high.

4. Watch for traps and trade them instead of the breakout. If you are frustrated with trading breakouts that fail (bull and bear traps) then don’t trade the breakout. Instead, simply watch for a bull or bear trap and trade it. For example, you see a small range develop. The price pops above the range only to quickly drop back into the range and continue dropping. Enter a sell or order or buy a put to take advantage of the fact that the price couldn’t break out of the range higher, and is likely to head down and test the low of the range.

Expectations that don’t materialize are part of trading. Accept it and decide on a game plan for how you will handle these events. Most traders just get angry at the market; don’t be one of these traders. There are other options which allow you to turn a problem or “trap” into an advantage. No matter what method you choose, make sure to test it and assure its profitability over many trades before using the method with real money.

Bear Trap

What is a Bear Trap?

A bear trap is a technical pattern that occurs when the performance of a stock, index, or other financial instrument incorrectly signals a reversal of a rising price trend. A bull trap is thus a false reversal of a declining price trend. Bear traps can tempt investors into taking long positions based on anticipation of price movements which do not end up taking place.

Key Takeaways

  • A bear trap is a false technical indication of a reversal from a down- to an up-market that can lure unsuspecting investors.
  • These can occur in all types of asset markets, including equities, futures, bonds, and currencies.
  • A bear trap is often triggered by a decline that induces market participants to open short sales, which then lose value in a reversal when shorts are forced to cover.

How Does a Bear Trap Work?

A bear trap can prompt a market participant to expect a decline in the value of a financial instrument, prompting the execution of a short position on the asset. However, the value of the asset stays flat or rallies in this scenario and the participant is forced to incur a loss. A bullish trader may sell a declining asset in order to retain profits while a bearish trader may attempt to short that asset, with the intention of buying it back after the price has dropped to a certain level. If that downward trend never occurs or reverses after a brief period, the price reversal is identified as a bear trap.

Market participants often rely on technical patterns to analyze market trends and to evaluate investment strategies. Technical traders attempt to identify bear traps and avoid them by using a variety of analytical tools that include Fibonacci retracements, relative strength oscillators and volume indicators. These tools can help traders understand and predict whether the current price trend of a security is legitimate and sustainable.

Bear Traps & Short Selling

A bear is an investor or trader in the financial markets who believes that the price of a security is about to decline. Bears may also believe that the overall direction of a financial market may be in decline. A bearish investment strategy attempts to profit from the decline in price of an asset and a short position is often executed to implement this strategy.

A short position is a trading technique that borrows shares or contracts of an asset from a broker through a margin account. The investor sells those borrowed instruments, with the intention of buying them back when the price drops, booking a profit from the decline. When a bearish investor incorrectly identifies the decline in price, the risk of getting caught in a bear trap increases.

Short sellers are compelled to cover positions as prices rise in order to minimize losses. A subsequent increase in buying activity can initiate further upside, which can continue to fuel price momentum. After short sellers purchase the instruments required to cover their short positions, the upward momentum of the asset tends to decrease.

A short seller risks maximizing the loss or triggering a margin call when the value of a security, index or other financial instrument continues to rise. An investor can minimize damage from bull traps by placing stop losses when executing market orders.

Bull Market

What is a Bull Market?

A bull market is the condition of a financial market in which prices are rising or are expected to rise. The term “bull market” is most often used to refer to the stock market but can be applied to anything that is traded, such as bonds, real estate, currencies and commodities. Because prices of securities rise and fall essentially continuously during trading, the term “bull market” is typically reserved for extended periods in which a large portion of security prices are rising. Bull markets tend to last for months or even years.

Bull Market

Understanding Bull Markets

Bull markets are characterized by optimism, investor confidence and expectations that strong results should continue for an extended period of time. It is difficult to predict consistently when the trends in the market might change. Part of the difficulty is that psychological effects and speculation may sometimes play a large role in the markets.

There is no specific and universal metric used to identify a bull market. Nonetheless, perhaps the most common definition of a bull market is a situation in which stock prices rise by 20%, usually after a drop of 20% and before a second 20% decline. Since bull markets are difficult to predict, analysts can typically only recognize this phenomenon after it has happened. A notable bull market in recent history was the period between 2003 and 2007. During this time, the S&P 500 increased by a significant margin after a previous decline; as the 2008 financial crisis took effect, major declines occurred again after the bull market run.

Characteristics of a Bull Market

Bull markets generally take place when the economy is strengthening or when it is already strong. They tend to happen in line with strong gross domestic product (GDP) and a drop in unemployment and will often coincide with a rise in corporate profits. Investor confidence will also tend to climb throughout a bull market period. The overall demand for stocks will be positive, along with the overall tone of the market. In addition, there will be a general increase in the amount of IPO activity during bull markets.

Notably, some of the factors above are more easily quantifiable than others. While corporate profits and unemployment are quantifiable, it can be more difficult to gauge the general tone of market commentary, for instance. Supply and demand for securities will seesaw: supply will be weak while demand will be strong. Investors will be eager to buy securities, while few will be willing to sell. In a bull market, investors are more willing to take part in the (stock) market in order to gain profits.

Market Mentalities: Bulls Vs. Bears

Bull vs. Bear Markets

The opposite of a bull market is a bear market, which is characterized by falling prices and typically shrouded in pessimism. The commonly held belief about the origin of these terms suggests that the use of “bull” and “bear” to describe markets comes from the way the animals attack their opponents. A bull thrusts its horns up into the air, while a bear swipes its paws downward. These actions are metaphors for the movement of a market. If the trend is up, it’s a bull market. If the trend is down, it’s a bear market.

Bull and bear markets often coincide with the economic cycle, which consists of four phases: expansion, peak, contraction and trough. The onset of a bull market is often a leading indicator of economic expansion. Because public sentiment about future economic conditions drives stock prices, the market frequently rises even before broader economic measures, such as gross domestic product (GDP) growth, begin to tick up. Likewise, bear markets usually set in before economic contraction takes hold. A look back at a typical U.S. recession reveals a falling stock market several months ahead of GDP decline.

How to Take Advantage of a Bull Market

Investors who want to benefit from a bull market should buy early in order to take advantage of rising prices and sell them when they’ve reached their peak. Although it is hard to determine when the bottom and peak will take place, most losses will be minimal and are usually temporary. Below, we’ll explore several prominent strategies investors utilize during bull market periods. However, because it is difficult to assess the state of the market as it exists currently, these strategies involve at least some degree of risk as well.

  • Buy and Hold

One of the most basic strategies in investing is the process of buying a particular security and holding onto it, potentially to sell it at a later date. This strategy necessarily involves confidence on the part of the investor: why hold onto a security unless you expect its price to rise? For this reason, the optimism that comes along with bull markets helps to fuel the buy and hold approach.

  • Increased Buy and Hold

Increased buy and hold is a variation on the straightforward buy and hold strategy, and it involves additional risk. The premise behind the increased buy and hold approach is that an investor will continue to add to his or her holdings in a particular security so long as it continues to increase in price. One common method for increasing holdings suggests that an investor will buy an additional fixed quantity of shares for every increase in stock price of a pre-set amount.

  • Retracement Additions

A retracement is a brief period in which the general trend in a security’s price is reversed. Even during a bull market, it’s unlikely that stock prices will only ascend. Rather, there are likely to be shorter periods of time in which small dips occur as well, even as the general trend continues upward. Some investors watch for retracements within a bull market and move to buy during these periods. The thinking behind this strategy is that, presuming that the bull market continues, the price of the security in question will quickly move back up, retroactively providing the investor with a discounted purchase price.

  • Full Swing Trading

Perhaps the most aggressive way of attempting to capitalize on a bull market is the process known as full swing trading. Investors utilizing this strategy will take very active roles, using short-selling and other techniques to attempt to squeeze out maximum gains as shifts occur within the context of a larger bull market.

Key Takeaways

  • A bull market is a period of time in financial markets when the price of an asset or security rises continuously.
  • The commonly accepted definition of a bull market is when stock prices rise by 20% after two declines of 20% each.
  • Traders employ a variety of strategies, such as increased buy and hold and retracement, to profit off bull markets.

Bull Market Example

The most prolific bull market in modern American history started at the end of the stagflation era in 1982 and concluded during the dotcom bust in 2000. During this secular bull market—a term that denotes a bull market lasting many years—the Dow Jones Industrial Average (DJIA) averaged 16.8% annual returns. The NASDAQ, a tech-heavy exchange, increased its value five-fold between 1995 and 2000, rising from 1,000 to over 5,000. A protracted bear market followed the 1982-2000 bull market. From 2000 to 2009, the market struggled to establish footing and delivered average annual returns of -6.2%. However, 2009 saw the start of ten-year bull market run. Analysts believe that the last bull market started on March 9, 2009 and was mainly led by an upswing in technology stocks.

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