The bull trap has been around for pretty much as long as people have been trading in and manipulating the price action of financial markets. Bull traps often catch unwary forex traders by surprise when they act on a false buy signal in an uptrend that then causes them to wind up taking a loss when the fake rally eventually fizzles out.
In this article, Benzinga explains the nature of the bull trap, its causes and how to identify and avoid them when trading forex. Knowledge of bull traps could improve your overall forex trading results, so keep reading for more information on bull traps in forex trading.
What is a Bull Trap?
As the name implies, the bull trap essentially consists of an upward-trending market that looks like it should continue higher, but the bullish move instead fails and the market moves lower.
Bull traps are notoriously created by market manipulators to trick other market participants into buying during a false breakout that looks like a bull market, thereby “trapping” them with positions on the long side.
The false upside breakout seen in bull traps generally induces less market-savvy traders to position themselves on the long side with a price target that the market never attains. As the market typically retraces its initial gains and then some during a bull trap, they eventually end up on the wrong side of market price movement (or exchange rate movement in forex trading).
The failure of the upside breakout of a resistance level, trendline or chart pattern eventually becomes apparent when market momentum wanes as the manipulator sells to take their profits. The ensuing selloff intensifies as traders on the wrong side of the market rapidly liquidate their positions. This tends to drive the market even lower than the level where the manipulation began, making a bull trap a bearish signal.
Causes of a Bull Trap
Bull traps occur in the forex market when a false signal that a currency pair is about to continue or accelerate its upward trend occurs. This bullish signal leads traders to buy the currency pair at higher and higher exchange rates before the trend reverses and the exchange rate drops, often breaking back below the region where the initial signal was observed.
A common cause of a bull trap is initial market manipulation followed by a lack of buyer support after a manufactured breakout. Once the initial buying that caused the breakout comes to an end, the market quickly reverses and even begins trending lower
For example, a bull trap can occur when a breakout takes place above a previous resistance level or a well-established trendline. Technical traders who all see the same market data might observe such a breakout. They then either jump in to take a position immediately or wait for a confirmation of the breakout if they are more experienced and patient.
In forex trading, bull traps often happen when a significant economic or geopolitical event triggers a surge in demand for a particular currency pair. This situation leads unwary traders to assume that the up trend will continue. But market sentiment can quickly shift because of various factors such as negative economic news or changes in interest rates. This can lead to a reversal of the perceived bull trend.
Large market manipulators can also create bull traps in the forex market by giving others a false impression of a bullish market. They might do this by executing large trades to create unfounded momentum in a particular currency pair that forces a breakout that looks very bullish to other traders. They can also spread positive news or rumors to influence the market sentiment in their favor.
Once the currency pair reaches a peak, manipulators can sell their holdings. This causes the exchange rate to drop sharply so they can potentially earn a profit. Manipulators can also use bull traps to force other traders to exit their short positions by triggering stop-loss buy orders that are commonly used by traders to limit their losses.
To avoid falling into a bull trap in the forex market, you can analyze market trends and news carefully before making any trading decisions. Technical analysis can also be used to confirm breakouts. Finally, you can also identify potential resistance and support levels to help you to set stop-loss and take-profit orders at appropriate levels.
How to Identify a Bull Trap
Accurately identifying a bull trap in the forex market typically requires a combination of technical, fundamental and sentiment analysis. You can also use exchange rate charts to spot potential bull traps. The useful market analysis methods that can help you identify a bull trap in the forex market include:
- Technical analysis: A key method for identifying bull traps is to use technical analysis tools like trend lines, support and resistance levels, moving averages and oscillators to analyze the exchange rate movements of a currency pair you think has shown a bullish signal. A break in a key support level, or a bearish divergence in a momentum oscillator like the relative strength index, can indicate a potential bull trap you will want to avoid. Charts can also be used to spot bull traps in the forex market. For example, you can review candlestick charts to look for patterns that suggest a downside reversal in the underlying trend. A particular candlestick pattern known as a shooting star often indicates that a bearish reversal is imminent, as do bearish engulfing patterns and doji candles.
- Fundamental analysis: Another useful method that can help you avoid trading on bear traps involves using fundamental analysis to analyze the underlying economic and geopolitical factors that could have influenced the market sentiment to result in a bullish breakout. If the market sentiment does not seem that bullish based on positive news, then forex traders need to be cautious about the upside breakout and look for potential negative factors that could reverse the trend lower.
- Volume analysis: You can use trade volume analysis to identify when a forex market move is valid. True bullish breakouts are generally supported by strong trading volume that indicates a genuine upward trend has commenced. In contrast, bull traps are usually not accompanied by a significant increase in trading volume, so a failure to see such an increase indicates a potential downside reversal could occur instead of a rally.
- Sentiment analysis: Another method you can use to identify a bull trap is to analyze market sentiment using sentiment indicators or news sentiment analysis. If the market sentiment is overly optimistic and most traders have positioned themselves in the same direction, then traders need to be cautious because this could indicate a potential bull trap.
Keep in mind that remaining vigilant while trading currencies is crucial to avoid falling into a bull trap. You especially need to stay aware of potential market-moving events and news that could influence forex market sentiment and spark a reversal. Also, remember to set appropriate stop-loss orders to limit your losses in case the market moves against your position.
Example of Bull Traps
Even though the forex market is huge, bull traps remain common and can lead to significant losses for unwary traders who fall into the trap. For an example of a bull trap in the forex market, consider a situation where the EUR/USD currency pair is currently trading just below an exchange rate of 1.1. Trader sentiment may be mildly bullish on the euro because of positive economic data from the European Union, so the market has pushed up to test key psychological resistance seen at the round 1.1 level.
A large market manipulator then decides to take advantage of the growing bullish sentiment by executing a large buy order in the EUR/USD currency pair to create even more upside momentum. Other market participants see this push and also start buying the euro, thereby causing the exchange rate of the EUR/USD currency pair to rise above psychological resistance at 1.1 to 1.105.
At this point, many market participants assume that the bullish trend will continue, so they start buying more of the currency pair. This causes the exchange rate to rise even higher to 1.11. The market participants' buying frenzy and the bullish breakout attract even more traders, leading to a further increase in demand for the currency pair to 1.115.
The market manipulator who initiated the bullish momentum then takes advantage of the buying frenzy and starts selling out their long position, which causes the exchange rate to quickly drop back to 1.105. This sudden exchange rate fall causes some traders with long positions to panic and exit their trades by selling their positions, especially when the market falls below the 1.1 level where EUR/USD was trading before the bullish momentum began. This causes a further drop to 1.095, which in turn triggers more stop-loss sell orders.
These sales then further exacerbate the selling pressure, causing the currency pair exchange rate to drop to 1.09. At this point, some traders might realize that the bullish trend in EUR/USD is reversing, so they start selling out their long positions, leading to a further drop in the currency pair’s exchange rate.
Eventually, enough sales have occurred to turn the market sentiment bearish, and the EUR/USD currency pair falls to 1.08 and starts a new bear trend. Some traders who bought the currency pair at the peak of the now-failed bullish trend may still be holding long positions that are underwater.
This scenario is a classic example of a bull trap in the forex market. The market manipulator first created a false impression or signal of a bullish market by executing a large buy trade. This led other traders to assume that the trend would continue and push the market higher. The manipulator then took advantage of the buying frenzy to exit their long positions, which caused the market to fall below its initial level and trap the once-bullish traders who bought at the peak of the failed up trend into taking losses.
How to Avoid a Bull Trap
Because of the prevalence of bull traps in the forex market, you will generally want to include strategies for avoiding them in your trading plan. Here are some tips and tricks forex traders can use to avoid falling prey to bull traps:
- Use a combination of analysis methods: Traders should generally use a combination of technical, fundamental and sentiment analysis to identify potential bull traps. This helps to avoid relying on one analysis method and increases the accuracy of identifying real bullish moves and potential trend reversals before they occur.
- Stay aware of market-moving events: Traders should stay up to date on important news events that can shift the forex market sharply like economic releases, central bank meetings and geopolitical developments. Such news can impact forex market sentiment and trigger bull traps.
- Use appropriate risk and money management: Traders should use appropriate risk-management strategies like setting stop-loss orders, taking profits at regular intervals and avoiding over-leveraging their positions as well as using sensible position-sizing techniques. Taking such steps can help minimize losses and protect trading capital.
- Avoid chasing a new trend: Traders should avoid chasing an unconfirmed trend by buying at the peak of fresh bullish momentum. Instead, they can wait for a pullback in the currency pair’s exchange rate before entering a long position.
- Avoid trading during periods of low liquidity: Traders should avoid periods of low market liquidity because manipulators can use this to their advantage. Low liquidity can also increase the volatility of the forex market and lead to unpredictable exchange rate movements that can trigger bull traps.
- Use market action analysis: Analyze the way that exchange rates move on candlestick charts to identify potential bull traps. For example, you can look for bearish candlestick patterns like shooting stars, bearish engulfing patterns and doji candles to signal a market entering a bull trap that may be about to reverse direction.
Traders can typically avoid bull traps by remaining vigilant to the risk of trading on them and using a combination of analysis methods to identify them. They can also employ appropriate risk- and money-management strategies and best trading practices to increase their chances of success and minimize their losses just in case a bull trap occurs that catches them long and wrong.
Bull Trap vs. Bear Trap
Bull traps and bear traps are both common in the forex market. Currency traders must remain aware of the signs and signals of each of these traps to avoid falling prey to them and losing money unnecessarily.
The primary difference between forex bull traps and bear traps is the direction of the exchange rate movement as the trap is developing. Bull traps occur when there is a sudden rise in a currency pair’s exchange rate to create the appearance of an uptrend, while bear traps happen when an exchange rate suddenly drops to give the impression of a downtrend or bear market.
Both bull traps and bear traps can be caused by large market manipulators who create a false breakout and may even attempt to influence market sentiment with rumors. The manipulators will aim to engineer a false bullish market sentiment in bull traps, but a false bearish sentiment in bear traps.
The consequences of both bull traps and bear traps can include significant losses incurred by gullible traders who fall prey to the trap. In general, bull traps will result in losses for duped buyers, while bear traps resulting in losses for duped sellers. Both types of market traps typically result in profits for the market manipulator.
Bull Trap Takeaways
Because bull traps are a common occurrence in the forex market, currency traders must remain aware of the signs and signals of market manipulation to avoid falling prey to them and losing their hard-earned money. Forex traders with open positions and those considering taking a position also need to stay well-informed and regularly updated on market-moving events to minimize the risk of losing money because of bull trap fakeouts.
Remember that bull traps are often caused by market manipulators who deliberately create a false bullish sentiment in the forex market. This can cause unwary currency traders to buy at the peak of an invalid uptrend and suffer significant losses as a result. You can typically increase your chances of success and minimize your losses as a trader by avoiding falling into bull traps.
In addition, those looking to avoid bear traps should consider using a combination of analysis methods and appropriate risk- and money-management strategies as well as best practices like avoiding chasing the trend on a suspicious breakout and trading during low liquidity periods when the market manipulation that causes bull traps is easier and more likely.
Frequently Asked Questions
Is a bull trap bullish or bearish?
A bull trap is a false bullish signal that initially sees the market rise as unwary traders are tricked into buying at or near the peak, but it ultimately results in a bearish market move that causes those same traders to take losses.
Can a bull trap go above the previous high?
Yes, the market can go above its previous high during a bull trap, but it then falls sharply. This traps unwary traders who bought at the peak of the false bullish trend and causes them to take losses.
Is a bull trap good?
A bull trap occurs when the market is pushed up sharply by a manipulator to create a false bullish sentiment that then traps unwary traders into buying near the peak of the fake uptrend that subsequently reverses to the downside. A bull trap is not good because it generally involves the market manipulator making profits by intentionally tricking other traders into losing money.