What is a Bull Trap?
A bull trap occurs when longs take on a position when a stock is taking off, only to have the stock reverse and shoot lower. This counter move produces a trap and often leads to sharp sell offs. If you haven't encountered a bull trap, then you don't know about pain. After trading for 14 years, getting caught in a trap is one of the worst feelings in the world.
The reason bull traps are tough for new investors is the emotional aspect of the trade. Think about it for a second. For most new traders you will enter your position with some level of apprehension because you are unsure about taking the position in the first place. Then something miraculous starts to happen. The stock you were just worried about begins to rally and not just rally but does so with price and volume.
In the flash of an eye, all of the worry washes away from you and your confidence begins to build. Then just as quickly as you feel you are in control of the situation, you wake up to a morning gap down or if you are day trading, the stock just plummets on high volume.
At this point you have just entered what I like to call the freeze phase. This is where you know you should sell, but are unable to because you believe the stock will come back.
Throughout this article I will provide you one simple tip for how to successfully trade the bull trap pattern.
Bull Trap Setup
Bull traps have a very basic setup. You will want a recent range broken to the upside with preferably high volume. The stock will need to get back below the same resistance it just surpassed. 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.
Tip - Don't Panic
You went to bed and your long position was safe and sound. You could be up anywhere from 10% - 30%. The reason I'm giving this range, is because if you are up several hundred percent than a gap down will have little impact on your emotions, unless the company is going through something catastrophic.
Now, back to our more realistic scenario. So, you go from being up 10% - 30%, to now a losing position. The first thing you want to do is not panic. If you were up on the position, and are now slightly down you have only given back your paper gains. Immediately look to the left of the chart to identify key support areas. This will give you some indication of how much further the stock could go lower. You want to identify the next two or three support levels lower. This will mentally prepare you for the very real possibility that the stock could continue even lower without much of a fight.
Now that you have your "worst case" scenario, start to analyze your risk exposure. Are you now risking 10% or 30%? Once you figure this out, you next need to accept the risk. Please read this sentence again, because I really want you to understand that you are now taking full ownership of the trade. At this point you should have a clear head. Now it is only a matter of allowing one of two things to play out.
(1) The stock continues lower and your stop is triggered or (2) the stock reverses after some period of time, heads higher and you come out on top.
Let's look at a real-world example from my own trading, where I did not accept the risk and therefore took an unnecessary loss.
Real-Life Example of You can Lose Money Panicking
I had my eye on Zynga (ZNGA) for quite awhile and decided to go long on 7/24/2013. I took a long position at $3.28 and the stock immediately started to rally. Fast forward one day later and ZNGA hit an intraday high of $3.62 which was a gain of slightly over 10%. If you are not in control of your emotions, a quick 10% gain can cause a bit of an ego trip.
Now skip to day two of the trade and you will see that the stock not only gapped lower, but went well below my entry point, all the way to a low of $2.85.
From what I remember, I felt sick to my stomach on the morning of July 26th. It wasn't just that I was in a losing position, but I also have a rule to avoid stocks right before their earnings, because the ensuing moves have very little to do with technicals and more to do with raw human emotions. I beat myself up the entire pre-market from 8am to 9:30am when ZNGA opened.
Do you want to know the end result of beating myself up for an hour and a half? I was in such a panic state, I sold out of the position at 9:31 am at $2.88 cents for an ~12% loss.
You thought this was bad. Well sit back and get your popcorn, the story gets worst. So, as expected ZNGA drifts lower over the next few weeks to make an ultimate low of $2.72. So, this would have meant I would have been down a total of 17% percent had I stayed in the position. Sounds bad, but being down 17% is not the end of the world.
Take a look at what happened next.
So you could be saying to yourself, well this trade worked out, but what if Zynga had tanked and you loss way more money. This is a fair point of view; however, back to what we discussed earlier in the article, had I looked back a few months I would have noticed the last swing low on ZNGA was $2.50. While this would have been a larger loss than me closing my position at $2.88, it just proves my point that I was not willing to lose the money. I had opened the position, placed a stop loss order, but I wasn't truly comfortable with the fact the market can at times go against you quite violently.
What Happens When you Don't Panic
I would be re-missed if I just left you with a depressing article of how panicking cost me money. So, let me show you how I have matured in a short period of time to learn when I am "jammed up" and how to manage the trade effectively.
Let's first set the record straight, I am not suggesting that you should have huge stops of 30% or 40%. What I am saying is that once you have recognized you are in a trap (and no matter how good you are this will happen), instead of panicking think through the next level down where a bounce could begin to reverse the trap.
My next real-life example is of the biotechnology company Chelsea Therapeutics (CHTP). I bought the stock at $3.20 on 1/8/2014. This was my first trade of the New Year, so you can only imagine the psychological importance. Not to mention I had just hit another peak in my trading account; you could say I was riding on a bit of a high.
I should have known that I was in for a rude awakening. Sure, enough the market delivered me a nice piece of humble pie right on time.
CHTP like Zynga began moving immediately in my favor. By the close on the very next day, the stock closed at $3.57. This represented a paper gain of 11.5%. I was planning to close half of the position on a morning pop; however, the market had other plans. I remember sitting at my desk doing my pre-market scan of open positions and seeing a trade come through at $2.50.
I remember thinking, something must be wrong with my data feed. So, i went out to Google and typed in "CHTP quote" and again saw results of $2.50. Again, I figured there must be something up. so I went over to the official Nasdaq site. To my grim surprise, CHTP in fact was trading in the $2.50s. This represented a loss of over 20% and an ~30% swing down from the previous days' closing price.
I felt utter defeat as I looked onto the screen. I couldn't believe I was caught in yet another bear trap similar to Znyga, but also that my losses were far greater. I felt like a wounded soldier coming to the realization that I was going to lose in the field of battle.
But, then something started to happen. I said to myself, "You are in a losing trade and it's really bad. If you close the trade out here you will get the immediate relief of exiting the position, but remember what happened with Zynga". So instead of panicking I looked to the chart to see the next support level down.
As I scanned back through the chart I noticed a swing low at $2.02 and another one at a $1.68. For me this would have represented a potential loss of ~37% and 48% respectively. I sat at my desk and asked myself the very real question, "Are you prepared to lose this amount of money and more?".
There were a number of thoughts that went through my mind as I pondered through the various outcomes. How did I let it get to this point? Why would I allow a stop so large on one position?
At the end of it all, I accepted the fact that the "market happened" and there is nothing I can do about it. All I can do at this point is manage the risk. So, with that in mind, I placed a mental stop loss at $1.68 and I was going to let the market move in its desired direction.
When I looked at the chart, it appeared to be a massive shakeout, as CHTP had one of the highest down daily volume spikes in the stock's history. But hold on, things get worse.
I never read news, but sometimes desperation will push a trader to his limits. I read that the stock had gapped down due to some concerns around a pending FDA approval which would be announced on Tuesday and that the stock would halt trading on Tuesday for the news.
Let me tell you that from Friday until the close on Monday was one of the hardest periods for me in my trading career. Even though I just committed myself to the possibility of a loss down to $1.68, I couldn't stop myself from thinking, well what if the stock goes to 90 cents or zero! I mean we are talking about a biotech stock and we know how these have made and loss millions for a lot of people.
After it was all said and done, I elected to accept the risk. Good thing for me because the stock gapped up and I was able to make a quick 50% in less than a week. Now, I know this is not ideal, and I rarely find myself in this type of situation. The point is that when I did find myself in a jam, I did not panic. I believed in myself and was prepared for whatever the market had to bring my way.
There are probably a dozen or more methods for trading bull traps, but in the spirit of keeping things simple I have focused on the one thing that matters the most - DON'T PANIC.
Panic trading, happens far often than most people would like to admit. The reason is most traders are either in concentrated positions, or simply have not come to grips with the concept that they can lose the money. This leads to these bull traps, where the weak longs panic during climatic events and unload their shares to the smart money.
So, remember if the market goes against you in a violent way, your stop thresholds have been wildly exceeded and you feel complete hopelessness. Remember to take a deep breath, relax and manage the trade.