How to Trade
Trading the Bull Trap – Eliminating Losing TradesAugust 3, 2020
First of all, a warning: it is impossible to eliminate losing trades. In fact, the very concept of efficient financial markets rests upon the fact that there will always be winners and losers, and there is no way you will place yourself entirely in the party of the former. Otherwise, what’s there to learn from.
Now that that’s been dealt with, let’s talk about traps. Again, there is no such thing as a perfect signal. It’s like in most physical principles: there are no absolutes, only theories that have been tested so many times that their inclination towards absolute truth gets steeper and steeper. Thus, “the sun always rises in the east and sets in the west” is an observation that has been made so many times, it is considered an absolute truth that in about 5 billion years or so will be a truth no longer.
Confirm or Croak
The MACD crossing its signal line is considered a reversal signal, but it happens so many times, the more useful MACD indicators also include a histogram that provides confirmation of the signal. It mostly works, but looking for additional confirmation before trading against an existing trend is always a good idea. Candlestick patterns may have served the 18th Century rice merchant Munehisa Homma, but his was a rather simplistically designed market. Anyone who dared double-cross the Samurai rarely survived long enough to create much of a market distortion.
What is a Bear Trap or a Bull Trap?
When defining the Bear/Bull trap, always remember the term refers to the trader – a trap for bulls (because the market is actually bearish) and for bears (because it’s actually bullish).
A bull/bear trap is quite simply a false signal that involves a strong counter-movement that then reverses to the previous movement, then breaking the previous support/resistance level. In a Bull Trap, a falling asset will reverse into an uptrend, strong enough to convince bullish traders to go long but then reversing to break the previous support level. A Bear Trap, conversely, is a rising asset that reverses into a downtrend, then returns to nature, breaking the previous resistance level and taking the grudging bear trader with it to new heights.
Quite often, the trap is a result of buyers or sellers, respectively, failing to support the new (false) trend. In this case, identification is easy – simply seek confirmation in volume. A trend only becomes a trend when the consensus favours it. Another way is if a divergence on the MACD persists beyond the realm of good taste.
Identifying the trap candle
To identify a trap, we will look for a candle that ostensibly breaks the support/resistance level but then ends back above/below it. Thus, with a bull trap, a candle will form that crosses resistance but ends as a bear candle; in a bear trap, it will cross support but then turn bullish. Usually, this means a long wick in the false direction and nearly none in the correct one – a hammer for a bear, an inverted hanging man for a bull.
In all cases, a reversal pattern will be in effect – most probably some form of engulfment.
Most stock market bubbles are characterised by traps. 1929, 2008 and especially 2020 are excellent examples of bull traps:
As first hints of an emergence from the COVID-19 calamity pension and hedge funds reallocated profits to equities, assured by monetary easing in the form of lower interest rates, corporate bailouts and unprecedented asset purchases by central banks.
Fear of missing out creates a premature rush towards risk assets, and then the second wave emerges. Suddenly, all it takes is a minor disruption, such as a return to the US-Sino trade war, anti-government protests in Hong Kong, race riots in the US to generate a renewed emergence of contagion, and the renewed bear market is upon us.
The same occurred in 1929, where a 50-day bear market – considered by many to be a correction of the “roaring 20s” market jubilation – was followed by a 100-day recovery. This was a result of bankers pooling their resources to purchase dwindling stocks. However, with resources limited, what followed by a 2-year return to the downtrend in which all the purchasing in the world did little to counter the eventual collapse of an inflated bubble.
Nearly 100 years later, the world is emerging from lockdown but may soon have to re-enter a no-income framework. At that point, overleveraged households will begin selling assets at a loss, including assets that will drive down the markets. Once again, all the institutional financing won’t help, since it will merely serve to inflate debt that has no way of being repaid.
A 1929-style 90% loss is not inevitable.
The common thread –floundering production, easy credit and insurmountable debt, both on the household level and that of central banks.
And hence, the term: The Bear Market’s Bull Trap.
Bull/Bear Trap Trading
Luckily, trading CFDs entails the ability to short an asset. However, even if you intend to “play the trap”, there are precautions that should be followed.
The most important tool against a Bull/Bear Trap is your stop loss, but even then, you may not be able to enter one in a feasible manner. The moment you realise you’re in a trap, emerge. Close down the position, even if at a slight loss.
Regarding the first, though, since you will only be able to enter a stop loss below (in the case of a Bull Trap) your entry point, you might want to immediately thereafter redefine it as a trailing stop loss. By the time you have finished, you will see volume dropping off and perhaps even manage to wring an infinitesimal profit out of what will soon turn into a losing proposition.