Here's how you can identify and avoid 'bull traps' while trading

A 'bull trap' is a classic case of a false breakout. In general, buyers enter a trade with strong conviction of an upside. However, at times, the stock fails to deliver the upward move and instead hits the trader's stop loss or support levels. Such instances not only affect the trader's morale, but they also start to doubt their trading strategies. Every other triggered stop loss then induces “fear of uncertainty” in the trader and the feelings of “staying away” enters his/her system.

How to identify a bull trap?

Before entering into a trade, one needs to gauge the overall outlook of the stock market. If the trend is certain and upward, the trade you enter may not need extra caution. Trading with the trend also helps in building a strong “trading confidence”.

Moreover, one should have the knowledge of the sector or index from which you want to select a stock. In some cases, the market trend might be volatile, but some specific sector/ index may exhibit strong momentum. If the index outlook is positive, identifying a stock gets easier.

Avoid trading in stocks that are vulnerable to any corporate developments. Such situations exhibit uncertainty and potential volatility rise as the development starts to pour into the markets.

How to avoid a 'Bull trap'?

Once the stock breaks out, wait for the rally to sustain with decent volumes. Volatility in volume structure reflects uncertainty and indecision. It is better to hold nerves and let the price settle, keeping behind all the swings it has witnessed. 

Make use of two – three technical / price indicators for a substantial confirmation. One can rely on a single indicator, however, having more than one indicator helps gauge the right momentum. That said, having more than three indicators can also create confusion. Thus, the ideal strategy should be to rely on limited technical indicators.  

Indicators to track

Moving Averages: The major moving averages are 50-day moving average (DMA), 100-DMA and 200-DMA. While identifying a trade, list down stocks that are trading above these averages. Trading in stocks hovering below these averages increases the risk in terms of identifying strength, direction and momentum.

Chart Patterns / Candlestick patterns: Chart patterns like Inverse head and Shoulder, Double bottom, Falling channel pattern, Symmetrical triangle, and Ascending triangle assist in confirming a positive outlook. Candlestick patterns like Bullish engulfing, Morning Star, Piercing line, Three White soldiers, and Hammer are bullish indicators.

RSI, MACD: The two widely used indicators are Relative Strength Index (RSI) and Moving Average Convergence Divergence (MACD). RSI determines the strength in oversold and overbought conditions; also, crossovers determine the positive upside. Whereas, MACD facilitates in evaluating the underneath buying momentum, by identifying the direction on the zero line and crossovers.

One needs to develop strategies that provide confirmation based on the correlation of these indicators. A confirmed trade is said to have all these indicators giving a 'buy' signal. If any of the indicators isn't signalling a 'buy', it may increase the quantum of risk in a trade.

What to do when you fall in a 'Bull Trap'?

The first response should be to exit the trade, rather than getting emotionally attached to the feeling of making profit. If one fails to exit, the loss may widen and even lead to a disastrous situation going ahead. CLICK HERE FOR THE CHART

The price will tell you if it is a 'bull trap'. One way to identify a 'bull trap' is the swings with volatile volumes seen after the breakout levels. If the breakout is not a trap, then the price will show a consistent rise with closing above the previous high, at least for two – three sessions after the breakout neckline.