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Every sport has its trick play. A play where they fake movement in one direction to throw the defense off, only to move in the opposite direction.
While the crypto market has its playbook of trickery, today we will share a page out of the book called the bull trap. This pattern traps traders into buying while the market is still trending lower. And if you’re caught in this trap, the consequences can be quite severe.
Whether you’re retail or experienced traders, in this guide you will uncover the ins and outs of a bull trap. You’ll learn to hedge funds by avoiding these traps, based on an asset’s past performance, and by identifying them on a price chart.
What Is a Bull Trap?
A bull trap is when a steadily declining asset appears to reverse in a convincing rally but soon resumes its downward trend to even lower pricing.
Traders witness a downtrend and anticipate a bullish reversal, looking to buy the dip at a good price. After an investor buys in at the initial stage, the price breaks out and rallies beyond the key support zone or resistance level, but later retreats and resumes the downtrend. This pattern is completed when the price breaks down and creates lower lows, pushing the trader into a losing position. Hence, these breakouts can be considered a false signal, one of the worst-case scenarios a trader can anticipate.
Bull trap patterns are often referred to as a “dead cat bounce.” They are commonly seen in all markets, especially in crypto markets, due to frequent swift recoveries. Therefore, crypto traders may anticipate a bounce and buy tokens too early, leading to large losses and frustration.
What Does a Bull Trap Look Like?
There are essentially three parts that make up the perfect bull trap. We’ve illustrated them in the image below.
- Initial Downtrend — a steady decline in pricing
- False Rebound — a weak bounce higher in pricing that is relatively shallow
- Cascaded Selling — continued trend to the downside that breaks to a new low
A bull trap occurs when a false rebound traps bullish traders into long positions. In the illustration above, the market is correcting lower within an initial downtrend at point 1.
Then, traders anticipate the end of the correction and buy with the hopes of catching a good entry in the cryptocurrency at point 2. Perhaps their trade starts with an unrealized profit, but the attempted rally loses momentum and cannot be sustained.
Prices end up reversing lower as sellers overtake buyers, pushing the market down. When the market falls below the old low, the pattern is completed as the trader either stop the trade or is very deep in a floating loss (see point 3).
How Do You Identify a Bull Trap?
The essence of this pattern is when traders prematurely buy the dip in anticipation of a market low. It appears to the traders that the market downtrend is over. After they are in a long position, prudent and wise crypto traders will place their risk and a stop loss just below the old low.
The early entry into trade and false breakout higher cannot be sustained because the market lacks large buyers. As a result, sellers continue to overwhelm the scarce buyers, and the pricing is readjusted to lower levels.
However, the problem escalates for the buyer, whose trade begins to float at a small loss. The problem intensifies for the buyer as the market pricing keeps readjusting to lower levels.
As the market trends lower, it begins to trigger the stop losses placed by the long traders. When a long trade is stopped out, the trader has to sell.
As the stop loss is triggered, more sellers are added to the market. More sellers in the market generate lower pricing. This negative feedback loop generates strong downward momentum on prices, and the market moves very swiftly to the downside.
Indicators to Confirm Bull Traps
Crypto markets are notorious for sharp bullish reversals, and crypto traders don’t want to miss out on a bargain entry. As a result, traders enter at a low price, but it may not end up being the bargain price.
Given this challenge, we can identify signals through technical analysis and chart reading, which will alert us to the potential development of a bull trap.
First of all, after a steady decline prices will rally, but not very far. In the example above, Bitcoin falls 23% during its initial decline in May 2021. During the initial downtrend, prices will remain below the sloping resistance trend line.
This behavior suggests the mood of the market is still to the downside, and the door is open to a bull trap.
Secondly, a bull trap will experience a false rebound that is weak with no momentum. As a result, the market will have a difficult time breaking above technical resistance levels. These zones are horizontal resistance levels, at previous highs and lows, which the market cannot break.
Another symptom that the market is creating a bull trap is lack of range expansion. A “range” in trading has multiple descriptions. One of the meanings for “range” refers to the size of each candle. If the chart is a daily candlestick, then each candle represents that day’s range.
During the initial downtrend, range expansion will take place, indicating that momentum is strong. To reverse that trend, you need to see range expansion in which the trend moves higher and bounces. The lack of range expansion on the bullish bounce is a symptom of a weak bounce — and that prices are at risk for further correction.
Measuring range expansion is fairly simple. Try adding an indicator to the chart called “Average True Range.” Set the input parameter to “1”. This indicator will place a window with a line at the bottom of the chart that provides a range measurement for the previous candle.
If the rally after the initial decline occurs with the indicator staying the same or becoming smaller, then it suggests that no range expansion is taking place.
Additionally, the market will experience a lack of momentum evidenced by the Relative Strength Index (RSI) indicator. Many traders or investors use the RSI indicator for overbought, oversold readings and to confirm a reversal breakout.
For example, if the RSI has a hard time moving above the 50 centerline reading, this is indicative that a market shows indecision and is not yet recovering. Without momentum in the market, RSI readings will remain below 50.
Finally, the ultimate symptom of a bull trap is when prices break below the old/previous low. Traditional technical analysis will review price action in the form of old highs and lows.
A breakdown below the previous swing low continues a series of lower highs and lower lows, which is the definition of a downtrend.
As the bull trap is sustained, prices tend to correct swiftly to the downside. In the Bitcoin example above, the bull trap pattern shows that prices collapsed 42% within five days.
Common Bull Trap Examples
Crypto markets frequently trap most traders into buying too early. Let’s look at a couple of examples where the bull trap led to quick and large collapses in Bitcoin and Ethereum prices.
After topping on February 13, 2020, Bitcoin’s price began to correct lower and shaved 20% off its value (point 1 on the image above). Traders then saw a bounce develop as Bitcoin recovered some of those losses (point 2).
However, the technical indicators on the chart illustrate how this rebound is potentially a false recovery. Price is well below trend line resistance (point 3) and struggles to break above a horizontal resistance level (point 4). In addition, the recovery is not experiencing a range expansion (point 5). Lastly, the RSI indicator is unable to press above the median line at 50.
At this point, there is no evidence to suggest a meaningful low is in place for Bitcoin. As a result, Bitcoin is at risk of a bull trap.
Sure enough, Bitcoin reversed and fell through the old low two days later. This break below the old low led to a 58% collapse in the pricing over the next five days.
Bitcoin isn’t the only cryptocurrency susceptible to a bull trap. The bull trap was present on a 4-hour price chart of Ethereum the same way, right before it collapsed on May 19, 2021.
Ethereum entered a steady decline of 29% from May 12 to May 16 (point 7). ETHUSD began a seemingly convincing rally (point 8), but the technicals of the chart suggest otherwise.
First, Ethereum did not break the downtrend, as the price was below the trend line (point 9). Secondly, ETHUSD couldn’t even break a horizontal resistance line (point 10).
Also, the market was exhibiting range contraction (point 11), which is the opposite of a healthy rally. Lastly, RSI could not break above 50 (point 12), suggesting this rally could be a false recovery.
Ethereum eventually proved this was a bull trap pattern, as prices fell to retest the old low at $3,124. After that test failed, prices collapsed 40% in a short period — in this case, just a matter of hours.
How to Trade With a Bull Trap
In a bull trap, the trend is still declining, but the crypto trader is still buying. The risks for these traders lie in trading against the trend.
But the truth is that a trend can last much longer than anticipated. The best way to trade trends is to filter your trades in the direction of the larger trend. For example, in the bull trap pattern, the trend is still lower; you need to filter the signals. That way, you are taking on short-selling trades.
Therefore, identifying the resistance levels where you can initiate a short sell position is crucial. If the market bounces higher and witnesses the bull trap symptoms previously described, then you have strong potential for a continued trend lower.
Also, identify the old swing low on the chart, and place a sell stop order should a breakout occur. Use the cascading sell orders to your advantage and align your trades to the direction of the larger trend, which is lower.
Lastly, make sure to incorporate sound risk management techniques, like implementing a stop-loss order. If the trade doesn’t work out, a stop loss order will prevent a small loss from turning into a severe one.
All in all, the best way to trade a bull trap pattern is to follow the prevailing trend lower and look for short-selling opportunities, rather than buying opportunities. Claim Rewards to trade BTCUSD on Bybit
How to Avoid a Bull Trap
There will be times when you suspect a bounce in prices but are unsure if a true rebound will take place — or whether it may be a developing bull trap pattern. We never really know ahead of time, until there’s enough evidence that the rising prices appear to have some momentum behind them.
Always Check the Trading Volume
One of the best ways to avoid the bull or bear trap is to check the volume. Should there be any changes to the asset’s value but the volume remains unchanged, it could signal a trap is coming.
Wait for an Indicator to Confirm a Signal
Another way to avoid a bull trap is to wait for the indicators to provide enough evidence that the pattern is unlikely to develop.
Are prices breaking resistance trend lines and overhead levels of horizontal resistance? If these resistance levels break, then it is safer to go long.
Are you witnessing range expansion in the average true range (ATR) indicator? Not every candle will be larger, but you want to see the bullish candles larger than the bearish candles before going long.
Also, is your RSI oscillator breaking above 50? If so, this is evidence that the trend is gaining some momentum.
In April 2021, Ethereum exhibited technical signals that suggested a low likelihood of a bear trap. As illustrated above, Ethereum avoided the bull trap and ended up with a breakout, rallying 83% in value.
It can be challenging to wait patiently for some of these indicators to flash positive signals. However, if these symptoms are not present, the crypto market remains at risk of falling further — which means taking on losses in your trading account.
The Bottom Line
A bull trap pattern frequently occurs in crypto markets, as it is a false breakout signal to bulls that a rally is underway. In reality, the trend is expected to go lower, and the market continues to seek out cheaper pricing.
The best way to avoid these traps is to wait for the technical indicators to signal a bull trend is underway, which means waiting patiently. Do not expect the market to react the way you anticipate without the confirmation of proper indicators. Always do your due diligence — and know that you trade at your own risk.
Article originally published at: https://learn.bybit.com/trading/what-is-a-crypto-bull-trap-and-how-to-avoid-it/?medium=organic_social&source=twitter&channel=mkt_&campaign=learn&content=en_1&dtpid=1622789751598&%24web_only=true&_branch_match_id=906837917440112330