DEFINITION of 'Bull Trap'

A bull trap is a false signal indicating that a declining trend in a stock or index has reversed and is heading upwards when, in fact, the security will continue to decline. The move "traps" traders or investors that acted on the buy signal and generates losses on resulting long positions. A bull trap may also be referred to as a whipsaw pattern.

BREAKING DOWN 'Bull Trap'

A bull trap occurs when a trader or investor buys a stock that is about to breakout above a resistance level - a common technical analysis-based strategy. While most breakouts are proceeded by strong moves higher, there are some cases when the stock quickly reverses direction. These are known as "bull traps" since the traders and investors that bought in are "trapped" in the trade.

Traders and investors can avoid bull traps by looking for confirmations following a breakout. For example, a trader may look for higher than average volume and bullish candlesticks following a breakout to confirm that the price is likely to move higher. A breakout that's proceeded by low volume and indecisive candlesticks - such as a doji star - could be a sign of a bull trap.

From a psychological standpoint, bull traps occur when bulls fail to support a rally past a breakout level, which could be due to a lack of momentum or profit-taking. Bears may jump on the opportunity to short-sell the stock to send prices back below resistance levels, which can then trigger stop-loss orders from the originally bullish traders.

The best way to handle bull traps is to try and see the warning signs ahead of time, such as low volume breakouts, and then exit the trade as quickly as possible if a bull trap is suspected. Stop-loss orders can be helpful in these circumstances - especially if the market is moving quickly - to avoid letting emotion drive decision making.

Bull Trap Example

In the example above, the stock reaches a new 52-week low before rebounding sharply on high volume toward trendline resistance. Some traders may have jumped onto the move anticipating a breakout from the trendline resistance, but the stock quickly moved lower from these levels. The bulls may have become "trapped" in the trade and experienced losses as a result.

The trader could have avoided a bull trap by waiting for a breakout before purchasing the stock or mitigated losses by setting a tight stop-loss order just below the breakout point.

Chart courtesy of TradingView.

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