After the brief increase in price, the market reverses direction again, returning to its downward trend and falling even more, usually below the level it was at when the bull trap began. Investors who fall for the trap (because they assumed the price would continue to rise) wind up buying an asset that continues to lose value.
Alternate name: Suckers’ rally
Imagine that stock XYZ has been performing relatively well, reaching a value of $50. However, XYZ’s performance begins to falter and it drops to $30 over the course of a few months. After reaching a price of $30, XYZ again begins to gain value, rising to $35. During this time, investors begin purchasing shares, expecting XYZ to return to its previous highs. Instead, XYZ drops again, falling to $20. This bull trap occurred when XYZ reached $30 and began to rise, tricking investors who believed it would continue to gain value into buying shares, only to see its value decline again.
How Does a Bull Trap Work and Why Does It Happen?
Bull traps occur for many reasons and it can often be hard to pinpoint just one reason why a bull trap occurs. One argument for why bull traps occur is that bullish investors see a stock they like reaching a low price. Those investors decide that it is time to purchase shares at what they perceive to be a discount to their fair value. The demand from those investors, along with short sellers buying back their shares, helps fuel an increase in the stock’s price. As it rises, other investors may fear missing out on potential gains and start purchasing shares as well, fueling further increases in value. Once the price of a stock rises beyond a certain point, investors who held shares through the downturn may decide they want to offload shares while they have an opportunity to do so. This increases the supply of shares compared to demand and leads to the return of the downward trend. An example of a market-wide bull trap would be what investors saw in the S&P 500 from 2007 to 2009. The S&P dropped 17% between October 2007 and March 2008. Over the next two months, the S&P recovered around half its losses. This was a bull trap, however, because the gains were short-lived. The S&P dropped to 683 by March 2009, the lowest point since 1996.
What It Means for Individual Investors
If you’re an individual investor who trades individual securities or who makes frequent trades in your portfolio, you should keep an eye out for bull traps. You may buy shares at what you think is a cheap price, only to find that they keep losing value. It can be very hard to identify bull traps compared to an actual reversal in a security’s price trend. Some experts recommend keeping an eye out for stocks that are reversing a price trend but have low trade volume, or if they break above their moving-average price, two popular technical indicators that could mean a bull trap. If you’re concerned about being caught in a bull trap, set a stop-loss on your position so your broker sells your position before the asset’s price drops too far. At the end of the day, it may be wise to avoid trying to time the market and instead buy into long-term investments or invest in more diversified securities, like mutual funds.
