Bear and Bull Traps – Use them, but Don’t be Abused by them

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The price breaks out in the direction you expect, and you jump aboard with a trade. Moments later, the breakout has failed, and you find yourself in a trade that is rapidly accelerating in the opposite direction. Welcome to bull traps and bear traps, terms used to describe an event where traders are trapped into thinking one thing is about to happen, only to have a bait-and-switched pulled on them. Here’s what bear and bull traps look like and how to use them instead of being victims to them.

Bear Traps and Bull Traps

Bear and bull traps occur in all markets and on all time frames. You see them when you day trade futures, and you see them in the forex market. When London opens in the forex market, it is very common to see a bull or bear trap. Typically there is low volatility overnight, and when London opens, the price moves outside that range (on one side or the other) only to move back the other way shortly after. Traders looking at the overnight session may view this as a breakout, and it may be, but it also could be a trap.

Since buying on new highs is a common strategy, many traders likely get caught by this type of price move–buying on the new high only to have it quickly move back the other way. This is called a “bull trap” because buyers (also called bulls) expect the price to go higher and buy in anticipation; it’s a trap because it didn’t work out.

The price then also breaks the overnight low, by a more significant margin, but then it too aggressively moves back the other direction–this traps the bears or sellers and is therefore called a “bear trap.” This was a particularly sinister day for those buying on new highs or selling on new lows because there is yet another bull trap, as the price rallies above the former high only to reverse quickly. The price then finally settles into a downtrend.

Dealing with Traps

There are several ways to deal with traps. Before getting into them, though, it is essential to point out that bear and bull traps are pretty common. Since they are common, it is important to accept that you’ll likely be caught in one at some point, and you do have options.

1. The first option is to do nothing. If you have a winning trading plan, losing trades happen. Accept that you may occasionally get stuck in a bear or bull trap and accept it.

2. Reverse. If you are an active trader and are comfortable with it, you can “flip” your position. Get out of the trade you’re in and go the other direction. For example, when you sell a breakout to the downside, the price moves slightly lower and then snaps back in the other direction. Exit the short or put, and go long or buy a call.

If you can’t exit your position, you may simply be able to “hedge.” For example, if you have bought a put, you can buy a call once you see the bear trap is occurring. The danger here is that it is possible to end up with two losses instead of just one.

3. Don’t buy breakouts to new highs or sell breakouts to new lows. This third option involves altering your strategies to avoid trade setups, resulting in bull and bear traps. While it is a personal choice–and not the only way to trade– I don’t buy when a new high occurs or sell when a new low occurs. For example, during a downtrend, you sell during pullbacks higher and exit just beyond former lows (basically, I am getting out on those traders who are just entering on the new low). I enter during pullbacks lower and exit the trade in an uptrend, usually just beyond a former high.

4. Watch for traps and trade them instead of the breakout. If you are frustrated with trading breakouts that fail (bull and bear traps), then don’t trade the breakout. Instead, simply watch for a bull or bear trap and trade it. For example, you see a small range develop. The price pops above the range only to quickly drop back into the range and continue dropping. Enter a sell or order or buy a put to take advantage of the fact that the price couldn’t break out of the range higher and is likely to head down and test the low of the range.

Expectations that don’t materialize are part of trading. Accept it and decide on a game plan for how you will handle these events. Most traders just get angry at the market; don’t be one of these traders. There are other options that allow you to turn a problem or “trap” into an advantage. No matter what method you choose, make sure to test it and assure its profitability over many trades before using the method with real money.

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