What Is a Bull Trap?
Bull Trap Meaning
A stock market bull trap occurs when investors buy as the stock price is declining or low, triggering an upward trend. The upward trend then reverses due to low purchase volumes, and the stock falls, further ‘trapping’ the buyer with loss-making stocks.
A bull trap is a type of value trap.
A whipsaw pattern, false breakout, and failed break are all terms that describe movements in the market that ‘trick’ investors.
Table of Contents
Explanation and an Example of a Bull Trap.
How does a Bull trap Work?
A Bull Trap versus a Bear Trap.
What does a Bull trap mean to investors?
Bull Trap Explained with Examples
A bull trap is a type of value trap. A value trap occurs when an investor looks at the fundamentals and market price of a stock, and it appears the stock is valued at a discount (cheap to own), but it ends up not being the case. The illusion causes the investor to think that they will invest in the stock and beat the market but provide either a negative or lacklustre return.
As the name suggests, the bull trap traps the bull, who bought the stock at a low price, with the anticipation of a continued rise in value; however, the surge is only temporary, and the trend reverses, with the stock value falling to lower values.
The bull is left with a loss-making stock.
The Bull Trap is a result of a volatile and unpredictable market. This is also referred to as a type of:
Whipsaw pattern: Definition from the verb whipsawed, as defined in the Merriam Webster online dictionary. Subjected to a double market loss through trying inopportunely to recoup a failure by a subsequent short sale of the same security. [1] Recent Examples on the Web:
‘Homes are selling during the coronavirus crisis, despite heightened unemployment, widespread business losses, a whipsawed stock market and stay-at-home orders.’— oregonlive, 11 Apr. 2020
An example is shown below:
Adani Enterprise was trading in a rectangle range for a few days, then gave a breakout, after that reversed to the open price. [2]
How Does a Bull Trap Work?
The Bull Trap is driven by the buy low, sell high concept. A low stock price stimulates investors to buy. The strategy is to entice a large volume of investors to join, thus shifting the price upward.
However, investors who have held the stock for some time take this opportunity to sell on the uptrend—the selling of the stock results in a down-turn in the stock price.
The stock does not return or challenge prior high prices as the buyers anticipated. This leaves those that bought at the lower price with a loss.
As used in news reports and articles, the term “Is it a bull trap or a true recovery?” Meaning is the stock going to continue to rise, or will it resume the downward trajectory.
The Difference Between a Bull trap and a Bear trap
The converse of a bull trap is a bear trap. The term bear trap is used to describe temporary downturns in a stock price. Bears sell as the stock price drops, anticipating a continued downward trajectory; however, they lose money when the trend changes direction and moves up.
What does It Mean for Retail Investors?
It is nearly impossible for both a Bull Trap and Bear Trap to know if you are dealing with a trap or a valid upturn or down-turn. Investors must be aware of these false patterns and conduct adequate research before any action. Research must go beyond the technical analysis of price charts, patterns, technical indicators, and market activity.
Conducting adequate due diligence is a way to help prevent an investor from falling into the value trap. One type of analysis that can help them identify external forces is a PESTEL analysis. By analysing the Political, Economic, Social, Technological, Environmental, and Legal macroeconomic parties, an investor can better equip themselves to determine if they are getting a deal on a stock or falling into a value trap.
Article Sources
“Whipsawed.” Merriam-Webster.com Dictionary, Merriam-Webster, https://www.merriam-webster.com/dictionary/whipsawed. Accessed 15 Aug. 2021.
Labya Singh. Director at RB India Services Private Limited.
