Warrior Trading Blog

Bull Trap: How to Avoid the Fake Bounce

Bull Trap

 

What is a Bull Trap?

A bull trap is a trading term that describes a false signal to bulls that the price is going higher, but really is just a fake move before going lower.

The increase has to be just enough to lure the bulls in, only for the stock to sink again, penetrating its lows. Traders also refer to this as a “dead cat bounce.” 

The key here is the perception of a trend reversal, just enough to lure in the “buy the dip” crowd. When the price begins declining again, these bulls are forced to sell out of their positions, adding more fuel to the fire. 

You’ll typically witness a bull trap shortly after a stock has a poor earnings report or scandal. Bulls for that stock will interpret this as a great buying opportunity but are typically blind to the weak technicals. 

Here’s a poorly drawn example of your typical bull trap or “dead cat bounce.”

 

As you can see, our hypothetical stock experienced a considerable decline, followed by a moderate uptick.

This uptick draws in the buyer “buy the dip” crowd, only to rip downwards and breakthrough the previous lows.

How To Spot a Bull Trap

Lack of Increase in Volume

Volume indicates interest. There’s a much higher likelihood that a price increase unaccompanied by a significant rise is simply robots and retail traders fighting it out.

A large volume spike means that conviction buyers have entered the fray. 

A conviction buyer is a catch-all term for well-capitalized individuals and funds who are establishing a long-term position and intend to add more on price declines.

These can be hedge funds, mutual funds, wealthy individual investors, etc. We can’t know, but we know they’re around when the volume increases considerably.

You can sort of “lean on” them for liquidity in the same way HFTs lean on us retail traders when scalping the order book. 

Lack of Momentum

Price momentum refers to the price’s rate of change. When a stock goes up or down very fast, that stock has a lot of momentum.

One of the tell-tale signs of a bull trap is when a stock has experienced a sharp downtrend or gap-down with giant red candles, but its uptick is tame. This is a simple comparison to make.

On the decline, you’ll typically see.

Here’s another poorly illustrated example of this. You see massive declines with no support from the bulls on the way down, followed by a timid response by the bulls.

Any considerable amount of selling would send this stock soaring below its previous lows.

 

You can’t expect a price reversal to the upside given the above price action. Trend reversals tend to be violent because almost everyone is on the wrong side of the trade, desperately trying to exit.

It’s like hundreds of people trying to cram through a bedroom door at once.

Lack of Trend Break

At its simplest, a downward price trend is a series of lower lows and lower highs. Advances in stock prices don’t necessarily change the trend.

So long as the price increase doesn’t exceed the most recent lower high, the downtrend is still intact. 

One of the most common pitfalls of those who get stuck in bull traps is the lack of confirmation. If the current high doesn’t breach the most recent high, it is either in a downtrend or in a range.

This would be considered “no man’s land” and is one of the worst locations to initiate a purchase unless you have another reason to do so.

Most traders are likely better off waiting for confirmation and buying at higher prices than trying to “get in early,” only to get trapped. 

Don’t Grab a Falling Knife

Even the strongest trends have slight pullbacks.

The nastiest breakouts take pauses. Even the crash of March 2020 saw wild rallies to the upside. The point is, bullish or bearish short-term price action doesn’t occur in a vacuum.

Everything needs to be viewed within the big technical picture.

One of the traps that bears are especially prone to in comparison to bulls is buying the “falling knife.”

Bears are typically economic optimists. They tend to believe in the US economy’s long-term growth prospects and have a strong bias towards buying on dips for this reason: it’s on sale!

This ultimately makes sense within the context of a long-term investment portfolio, but it’s poor trading. 

Unless you’re trading a mechanical mean reversion system in which you buy, which is overextended for a rapid spike, buying “falling knives” is a losing trading strategy. 

Take the below stock, SolarWinds (SWI). The catalyst is that its cybersecurity software, Orion, may have been used by hackers to compromise US government networks.

 

This is the type of stock that bottom hunters love to buy.

It’s part of the hot tech sector in a market where every dip gets bought. But look at how precipitous the decline has been, and compare it to the timid defense the bulls have made thus far.

This type of volume means giant holders are selling, and enormous positions take days to weeks to exit completely.

That’s not to say that this stock might not recover, but it’s just not at all the ideal setup. As traders, we must put our capital to the highest and best use regarding both time and returns. 

Bull Trap Example Broken Down

Below is a textbook example of a bull trap. I labeled each piece of evidence, which potentially would have tipped you off that this is a suboptimal long setup. 

 

Exhibit A: Failed breakout. The stock caught some upside momentum in early November and attempted to break above its October range resistance level but failed. 

Exhibit B: Significant price rejection from the resistance level. Not only did the stock fail to remain above the resistance level, but there was substantial supply at the resistance level, quickly pushing the price below the resistance level. These events tend to have a cascading effect, as other traders realize this rejection and sell their breakout trades, causing a “waterfall” like crash downward. 

Exhibit C: The stock is attempting a rally but can’t muster any momentum. Candle ranges are small and pale in comparison to the range of the decline. 

Exhibit D: Considerably reduced volume as the stock is advancing. The bears were very interested in selling during the decline, causing huge volume spikes. The bulls are comparatively uninterested and are not aggressively buying shares. 

Exhibit E: The stock never breached its previous high, so it’s still technically range-bound. Also, keep in mind that last support becomes resistance. The timid rally failed firmly within the support zone established in October. 

Bottom Line

After the Great Financial Crisis cleared up, “buying the f*cking dip” has become a part of US investing tradition.

Many sense that when things get bad, the Federal Reserve will step in and save the stock market from falling too much. It’s kind of like having free insurance against your portfolio.

As such, it’s become easy to justify buying just about any dip after telling yourself about how stocks always go up, etc.

You might be right in the long run, but blindly buying falling knives does not backtest nicely and works even more poorly in live trading.