A bull trap is a colloquial trading term that describes a common occurrence in the market where a stock that has been decreasing sharply seems to be halting or reversing its fall, but it is actually only a short pause before further declines in price.
Bullish investors are prone to become trapped in these bad trades, as they look to ‘catch the falling knife’ of an overblown selloff in a security and bet that it is set for a sharp upward reversal, yet the price continues to decline while the value of their position deteriorates.
Bulls and Bears
Bull and bear are terms used to describe traders with positive and negative market sentiments respectively. While these are not strict terms, and a single trader can be bearish toward one security while being bullish toward another, most traders do tend to lean toward one end of the spectrum.
Bullish traders are seeking out hidden value in a security while bearish traders are looking to discover negative features of a security that the market has overlooked. These different approaches to trading tend to favor certain personality types.
Bullish Traders and Bull Traps
Bull traps are deceptively inviting to bullish traders because substantial decreases in price do often lead to sharp upward reversals. The more substantial the initial decrease in price, the more that investors will panic and sell their rapidly depreciating position.
This creates an opportunity for bullish investors who believe that the initial panic must eventually pass and the security will rise back to a more reasonable price range.
However, there are numerous occasions where a floor or quick upward reversal in a falling price trend is just a pause before a continued rapid decline. Since the market is moving so quickly and reacting to sentiment during these situations, it can be extremely difficult to differentiate a floor or upward reversal from a bull trap.
Bull traps are particularly dangerous to bullish traders because the continued rapid price decrease after the pause or short reversal is often substantial, sometimes even more than the initial decline.
It can be very difficult to gauge when a falling price will stop and reverse, as investors are reacting emotionally to a rapidly developing situation.
Being able to identify the floor of a decreasing price is a great opportunity for bullish day traders, but it is very important to be aware of how common bull traps are in contemporary markets.