A bull trap occurs when a steadily declining asset appears to reverse and go upward, but soon resumes its downward trend.
Bull traps are false market signals that can take place on an asset, such as a cryptocurrency, that exhibits a strong long-term downward trend. A bull trap is also known as a “whipsaw pattern,” and refers to a false signal where a value of a stock, cryptocurrency, or any other kind of financial asset, displays a sign of recovery or reversal after a downtrend when in reality, the asset is actually set to decline further. In a bull trap, the price of an asset surpasses its previous support levels, enticing traders and long-term investors to open new long positions or purchase more of the asset.
Bull traps are notorious for being deceptive indicators that create dire consequences for players in all markets, which is why they are referred to as “traps.” In fact, they are one of the reasons why traders should be cautious of any sharp reversal of an asset’s price as soon as it finishes a breakout, which is a price movement below a support level. Unfortunately, most retail investors, especially in the crypto space, expect that a breakout will always be followed by a stronger price rally, which isn’t always the case.
Technical analysis is one of the most important tools available to day traders: it relies on analyzing price patterns and finding trading signals on an asset’s price chart in order to try to predict its future movements. One of the most important signals is the breakout above a resistance level, which occurs when the price chart goes above a certain line that has been repeatedly reached but never exceeded before.
This usually leads bullish traders to expect further price increases and go long on the asset. While that assessment is sometimes correct, a bull trap occurs when the signal turns out to be false and the price resumes its downward trend soon after the breakout above the resistance line. Thus, the bulls that have bought the asset get trapped in their trades that were based on the misleading signal.
Bull traps can be avoided by employing extra precautions, such as looking for additional confirmation signals of a prolonged bull run after the initial breakout above the resistance. Breakouts coupled with low trading volume are often a sign of an upcoming bull trap.
Since bull traps occur when bull traders fail to supply the upward trend of an asset following a resistance breakout, low trading volumes during breakouts are good indicators for such. Therefore, in order to prevent being a victim of a bull trap, always consider other indicators, such as trading volume and further price movements, before entering new positions following a price breakout. Most experienced market players refer to this as “confirmations,” whereby a trader further observes the movement of an asset in the next time period before coming up with a decision on whether to enter new positions.