How To Identify Bull Traps & Bear Traps

Identifying bear and bull traps

All specialized industries make use of technical terminology specific to their activities. The world of investment and finance is no exception and has a language all its own. Bullish, bearish, candlesticks, Ichimoku clouds, futures and options: it is enough to leave a newcomer's head swimming. Luckily for us, most of these terms represent concepts that are not so difficult to understand; it is simply jargon used by those in the know. Here we will take a look at a couple of these terms. More specifically, we will look into identifying bull traps and bear traps.

However, in order to do this, we first need a bit of background.

What Are Bears and Bulls?

When learning about cryptocurrencies, and all financial markets for that matter, the terms bear and bull (or bearish and bullish) are thrown around a lot. These expressions simply represent the direction of the market. In a bearish trend, the movement is falling, and in a bullish market the trend is rising. An individual investor can also be referred to as a bear or bull depending on their attitudes and expectations of the market. While the historical origin of these terms is unclear, the standard explanation is that a bull attacks by thrusting its horns up and a bear uses its paws to swipe down.

Two more useful terms to understand when exploring trading are “long” and “short” positions. A long position generally means that an investor buys an asset with the intention of holding it while the market rises and then selling later, when the price is higher. A short position—often, though not always, used to describe situations where an investor is dealing with borrowed assets—refers to a scenario where an investor sells an asset, hopefully before a downtrend with the hopes of buying it back at a lower price, and making a profit off the difference. Long positions are usually applied in a bullish market with rising prices and going short is a tactic in a bearish market when prices are falling.

Bull markets are characterized by confidence, optimism and positive expectations of market movements. Bear markets display negative investor attitudes, falling prices and a pessimistic outlook. Both of these phases are part of the economic cycle and offer valuable information on the state of a market.

However, as we will see, in the financial game, not everything is as it seems.

What is a Bull Trap?

Another term that may confuse anyone new to the industry is “bull trap”. What is a bull trap, when does it take place and how can we identify one?

As we have already discussed, a bullish market is characterized by a rising movement and investor confidence. In regards to trading, a trap is a sudden change of direction in the midst of an existing trend. In the case of a bull trap this means that during a period of falling prices—a bearish period—the market abruptly changes direction and begins to move bullishly. However, this shift doesn’t last.

Why is it Called a Bull Trap?

They are called “traps” because, either intentionally or not, investors can fall victim to these short-lived reversals to the detriment of their investments and position in the market. During a bearish market, investors are more likely to sell to get their investment back before prices fall any further, or take a short position in an attempt to profit on the decline in market prices. When a bull trap occurs, prices rise, moving against the downward trend. This can cause overly optimistic and unrestrained traders to act on this rising movement, often taking long positions on an asset with the expectation that prices will continue to rise.

This is where the “trap” comes in. This reversal is short-lived, leaving any unwary investors with an asset that quickly returns to its bearish movement. This can lead to investors being trapped in a long position on an asset that is continuing to fall, with little recourse but to sell for a loss or continue to hold until the market shifts back into a true bullish trend.

What Is A Bear Trap?

As you can imagine a bear trap functions on the same principles, only in an opposing direction.

During an up-trending, bullish market a reversal occurs, this time to a bearish trend. Bear traps can lead investors to believe that markets will continue to fall, and in turn, take a short position and sell assets. As the trend reverses again, back to its bullish movement, traders are forced to buy back at a loss or abandon trading until the market falls enough to buy back at a lower price.

As you can see, bear and bull traps can cause major problems for those that leap before they look. This is why it is important to examine market factors beyond simply the rising and falling of price trends. However, there are ways to avoid bear and bull traps.

How to Avoid Bear & Bull Traps

It is worth noting that bear and bull traps occur across all markets, and if you are a regular trader it is likely that, at one point or another, you will find yourself in a trap. Losses are a part of trading and a good trader will implement a strategy that takes losses into account. That being said there are signs to look for that can indicate these traps. Without diving too deep into candlestick charts and the other specialized tools that deserve entire articles in their own right, we can take a look at a couple tips that can help avoid these traps.

One, simple to understand yet sometimes difficult to implement, is to wait to trade on reversals. There is often a tendency when actively trading to jump at the chance of making gains and being the first to take advantage of changing market trends (see FOMO). While it is true that this can lead to profits, it can also drop you directly into a trap. Many experienced traders recommend waiting on these reversals until there is a confirmation and you are sure it isn’t a trap. This caution can actually allow a trader to take advantage of a trap and trade it for a profit.

Another useful tip for new traders is to understand that there are three entry points for every trade. The first is a predicting entry, often made by amateurs with less experience, that takes place too early and without any confirmation of a trend. The second entry may seem late to a new trader living that FOMO life, but it is safer and has a higher likelihood of producing profits. The last is a late entry that people talk themselves into making when they have missed the optimal entrance and are chasing profits. While this seems like common sense there are more complex ways to discern when these moments occur and how to take advantage of them using candle stick charts and their interpretation.

Bitcoin Bull Trap

As we have discussed these traps occur in all markets, and cryptocurrencies are no exception. Only recently there was an observable run in early September 2019 that lead many in the industry to speculate on when the bullish push would end. However, others were more skeptical. As noted by Martin Young in his piece for Bitcoinist from September 3rd, “Following a five-month volume dip yesterday, it has surged back to $17 billion today as the bulls keep the momentum going. There are mounting concerns that this could be another bull trap as there is still a strong possibility that the correction has not fully played out.”

As it happened, it was a bull trap. Prices continued to push into the first week of September, after which they began to take a turn towards a bearish trend. From there, Bitcoin began steadily dropping before plunging steeply on the 25th of September, from over $9,700 to under $8,500 overnight. While market movements are always a combination of different factors and influences, there is little doubt that Chinese President, Xi Jinping’s recent endorsement of the blockchain and related technologies played a role in this push. Some speculate that an overreaction to the significance of this announcement contributed to the reversal.

A Step in the Right Direction

There is no doubt that trading can be a risky enterprise. However, there are tools and strategies that can be used to manage these risks and eventually turn a profit.  Before any gains can be achieved, new traders must familiarize themselves with the different terminology and vocabulary used in the financial industry. While understanding bear and bull traps is just one step on a long journey to a successful trading career, these phenomena are essential for every trader to comprehend. There are countless examples of traders, in traditional markets as well as the crypto world, who have made careless moves and been caught in a trap. Exercising caution, due diligence and staying abreast of market factors are essential for all traders who wish to succeed in the industry.

 


 

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References

Farley, A. (2019, June 25). The 5 Most Powerful Candlestick Patterns. Retrieved from: https://www.investopedia.com/articles/active-trading/092315/5-most-powerful-candlestick-patterns.asp

Hill, A. (2019). Bull Trap – How To Escape The Setup. Retrieved from: https://tradingsim.com/blog/bull-trap-stocks/

Kramer, L. (2019, July 18). An Overview Of Bear And Bull Markets. Retrieved from: https://www.investopedia.com/insights/digging-deeper-bull-and-bear-markets/

Milton, A. (2019, May 5). The Difference Between Long And Short Trades. Retrieved from: https://www.thebalance.com/long-and-short-trading-term-definitions-1031122

Mitchell, C. (2019, June 27). Ichimoku Cloud Definition And Uses. Retrieved from: https://www.investopedia.com/terms/i/ichimoku-cloud.asp

Rolf. (2019). Are You A FOMO Trader? The Fear Of Missing Out. Retrieved from: https://www.tradeciety.com/fomo-trading-tips/

Young, M. (2019, September 3). Bitcoin Shoots To $10,450, But Is It Another Bull Trap? Retrieved from: https://bitcoinist.com/bitcoin-shoots-to-usd-10450-but-is-it-another-bull-trap/

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