Bull Trap Definition
A bull trap occurs when longs take on a position when a stock is breaking out, only to have the stock reverse and shoot lower. This counter move produces a trap and often leads to sharp sell offs.
Bull Trap Setup
Bull traps have a very basic setup. You will want a recent range to be broken to the upside with preferably high volume. The stock will need to get back below resistance within 5 candlestick bars, then explode out of the bottom of the range. The last component of the bull trap chart pattern is that the stock should have a decent price range. A wide price range is critical, as it increases the odds that the stock will have room to trend in order to book quick profits.
Why do Bull Traps produce sharp sell offs?
The first wave of selling will occur when the most recent swing low is exceeded, due to the number of shorter term traders who have their stops slightly below the most recent swing low. The second wave of selling comes into play once the strong longs realize that this is not just a slight retracement, but that the move has legs. This will produce the second round of selling, which will often precede the short-term low in the counter move.
Bull Trap Charting Example
Below is an example of a bull trap that takes place in Honeywell (HON) over two days from 9/6 – 9/7. HON broke out on the close of 9/6, only to gap down and break the low of the preceding range on 9/7. This sharp counter move created the perfect bull trap, hence the sell off you see below became a reality.