Bull Trap vs. Bear Trap: Online Trading Traps Explained
January 5, 2022
Online trading is potentially profitable but also fraught with pitfalls. The traps that can compromise investment activities are numerous and often difficult to avoid. However, two are proverbial and are the subject of extensive literature: the Bull Trap and the Bear Trap. Literally, the trap of the bull and the trap of the bear.
What are they? What consequences do they cause? How can they be avoided? In the following article, we provide answers to these questions.
What is the Bull Trap?
"Bull" signifies a bullish market phase in the investment world. The Bull Trap is, therefore, the trap that occurs when the market is in a bullish phase. It is referred to as a trap because it corresponds to an event that suggests a misinterpretation of facts. As a result, the trader executes wrong actions that lead to trade failures.
Specifically, the trap consists of the appearance of bearish signals within a bullish phase. The trader then has the feeling that prices are heading towards a trend reversal and acts accordingly. Often, they exit the market, thinking they have obtained the maximum possible profit at that juncture. However, the signal was illusory, and the price - maybe not immediately - continues its run, reaching even higher peaks compared to when the trader exited the market. In simple terms, the trader misses an opportunity.
In the vast majority of cases, the signal that gives rise to the Bull Trap is the breaking of a resistance level. The resistance is broken, but then the price, in fact, performs a reversal and starts rising again.
What is the Bear Trap?
The Bear Trap is specular to the Bull Trap but leads to similar, if not worse, consequences. "Bear" denotes a market in a bearish phase, with prices falling in a generally regular manner. In this case, the trap consists of the illusion that the bearish trend is about to turn into a bullish trend. Also, in this case, the trap is triggered by the breaking of a pivot point. Specifically, a support level.
The trader who falls into the trap, convinced that the situation is turning bullish, enters the market and takes a long position. However, their ambitions are frustrated, and the price soon returns to falling. At this point, there is no choice but to exit quietly, trying to contain the damage.
How to solve the problem of false signals
Both the Bull Trap and the Bear Trap represent a matter of false signals. Why do they occur? The reasons can be numerous. In most cases, an external factor intervenes that momentarily deviates the asset's path. It can be an economic or political event, an unexpected market mover, or even just a statement from an important think tank or policymaker.
This simple dynamic (but with disastrous consequences, as we have seen) also suggests the main solution to false signals: staying updated on what happens outside the market, practicing quality and, if possible, constant fundamental analysis, evaluating all signals in their context and not just focusing on charts, numbers, and prices.
There is also a method to avoid false signals, or at least try to avoid them, by acting directly on prices. That is, by continuing to practice technical analysis. For example, one could verify the signal in light of multiple indicators, so that one acts as a countercheck to the other. In the vast majority of cases, signals that are not confirmed by multiple indicators turn out to be false.
Another piece of advice is to identify the cases in which false signals are more frequent and avoid trading in those instances. For example, hectic phases, where volatility is more accentuated than usual, are the perfect breeding ground for false signals. Some are particularly skilled at riding the oscillations, adopting a highly speculative approach almost akin to scalping. However, it is a risky game, a double-edged sword.
A piece of psychological advice
Finally, a piece of psychological advice: don't become attached to an idea. Traders are people and therefore subject to rationality. Thus, they risk giving an event more weight than it deserves. If this event is a signal destined to prove false, then the damage is done.
How to act with rationality always and in any case? A certain amount of work on oneself is a must. However, it is possible to silence the mechanism of self-delusions by removing discretion from the trading activity. Those who trade according to a well-defined plan, which incorporates many events within it and provides a sort of instruction booklet that is always valid, are no longer prey to psychological pressure and consequently succumb to irrationality less frequently.
In particular, trading plans that integrate complex and pervasive money and risk management are effective. After all, psychological pressure stems precisely from the fear of losing money and the anxiety to earn it.
