What is a bull trap, and how to identify it?

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What is a bull trap in trading?
In trading, a bull trap is a situation where a trader buys an asset that he thinks its price will continue to rise, only to see it drop sharply after hitting a new high.

Bull traps occur during periods of market uncertainty or when misinformation about a particular asset is being traded. It is called a bull trap because no wiser traders make them believe that a falling asset is already in a bullish state. This false sense of security can take a heavy toll.

When a bull trap is suspected, traders should immediately exit the trade or enter a short position. Stop-loss orders can be useful in these scenarios, especially if the market is moving quickly, to avoid being swept away by emotions.

Related: Cryptocurrency Trading Basics: A Beginner’s Guide to Cryptocurrency Order Types

As with a lot of things in trading, identifying a bull trap can be tricky. However, the best way to avoid bull traps is to notice warning signs in advance – such as low-volume breakouts. We will discuss this in more detail below.

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How does a bull trap work?
Bull traps can have serious consequences for those who buy during the observed reversal.

Let’s say you are looking at a chart of an asset in a downtrend. After a while, the price reaches a point where it begins to consolidate sideways in what is called the “range”.

During this time, the bulls and the bears are in a fight as they try to push the price in opposite directions. Bears are trying to push the price down to new lows while the bulls are fighting to keep the price high.

At some point, there is a breakdown of the range when the bears win, and the price drops to a new low. Just when it looks like the downtrend is about to resume, the bulls come back and push the price to its previous high.

Many traders see this as a bullish reversal and start buying, believing that the downtrend is over. Unfortunately, this is usually only a temporary move, and the price quickly resumes its downtrend, which leads to huge losses for those who bought at or near the top.

What does a bull trap mean in the cryptocurrency market?
Also referred to as the “dead cat bounce,” bull traps are often seen in cryptocurrency due to the quick redemptions.

In crypto, bull traps work as they do in any other market. For example, if the price of an altcoin has been rising steadily over the past few days, you might think that it will continue to rise. You buy some and wait for the price to rise so you can sell it at a profit.

However, the opposite happens, and you find yourself trapped in a losing position. You are seeing a downtrend and then waiting for a bullish reversal when you can buy the dip, thinking you are buying the asset at a good price. The trap reveals itself as such when the price retraces and returns to the downside.

The role of psychology in bull traps
Bulls are chasing and driving peak bull conditions, which can all be well and good until the next bear market returns.

When this happens, they can fall into a bear trap where they may liquidate their positions at a loss. Due to a one-way mindset (strictly bear or bull), investors who are used to trading in a bull market may fall into the trap of buying high and selling low. Experts suggest having a two-way mindset to succeed in both bull markets and bear markets, as this allows for bigger profits during long-term trends.

What are bull traps used for?
Both day traders and long-term investors use bull traps to take advantage of unsuspecting market participants.

For day traders, a bull trap can be an opportunity to sell a security as it rises back to the previous high. Then the price resumes its downtrend, bringing profits to the trader.

For long-term investors, a bull trap can be an opportunity to buy securities at a lower price as they pull back after a rally. They can then maintain security for the next uptrend.

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What causes a bull trap?
Many factors lead to a bull trap, the most common of which is a lack of buying volume when rising to a previous high.

Weak buying volume is an indication that there is not much interest in the security at a particular low price and that the bulls are not strong enough to push the price higher.

Another common reason for bull traps is the false breakout of the consolidation pattern. The price breaks through the range to the upside, but then quickly pulls back and resumes its downtrend.

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