What is a bull trap?
Investors have different names for bull traps but the meaning is singular. A bull trap is the case where investors misread price signals of a currency pair after which they go long, only for the price to change course and continue trending downwards. Some investors call this bull market mirage.
In forex trading, investors follow different techniques in their daily activities. While some investors believe in position trading, others commit to scalping or arbitrage. Some combine all these strategies so long as they hit their profit targets within a given timeframe. However, sometimes the technique you employ does not matter if you are not ahead of the market. The desire to be a step ahead is the major reason investors get stuck in a bull trap.
Explaining the bull trap
How does a bull trap happen? Well, we are certain the need to answer this question is the reason why you read this far! A bull trap is everyone’s nightmare, especially noobs who rely on emotions to make trades. While you have access to excellent forex charting tools as well as the best forex indicators, the temptation to avoid these tools is great. Because technical analysis sounds so technical, investors tend to grow unwarranted fear of this excellent technique. This, dear investor, is the surest way into a bull trap!
To understand how a bull trap forms, let us consider a hypothetical investor who is watching his favorite currency pair, the EURUSD (Eurodollar). For the past one week, the Eurodollar has been in a steady decline as shown in the figure below.
The investor wakes up one morning and sees a breakout on the chart (Initial break on the chart). Without recourse to strategies using fundamental analysis or any other technique of market analysis, the investor enters a long position at the point of initial break. He gleefully watches as the bull rally builds, but all the color draws out of his face when the bull rally trap snaps. Noticeably, the currency pair matched onwards on the down low until it hit the ultimate bottom.
Why the bull trap happens
In a market downturn, many investors make profits by shorting assets. However, there is always the fear that the downturn may not go on forever, which is legitimate. During this period, investors do not take their eyes off their computer screens lest they miss the most crucial chart patterns that might signal an exhausted downturn. The slightest signal of this exhaustion has investors scrambling to be the first ones to take the front seat to ride up the bull-rally hill.
The desire to pick a bottom causes an initial buying spurt that bumps the price levels up above the prevailing chart levels. Consequently, a false breakout or a fake breakout (otherwise called afakeout) happens. This fakeout triggers more buying activity but it does not take long for the price to reverse.
Another reason for the development of bull traps involves the big boys of the currency marketplace. In the forex market, there is a hierarchy where large traders like banks and other entities determine Bid and Offer prices and hence the spreads. These players have access to the best forex indicators for automated trading as well as high frequency trading systems. Additionally, the big players’ share of liquidity of the market is disproportionate compared to retail investors. Therefore, they can change the course of the market price with a single order.
Let us say one large player intends to benefit from a downturn in the economy. During this time, the price of a given currency pair is falling. The big player can set up a bull trap after which he earns good returns. To set up the trap, the player buys large amounts of the currency pair hence creating a sudden but small jump in price. Retail investors quickly notice the bump and they start buying. After enough retail investors have fallen into the trap, the large player releases the trap and the bull market collapses.
How to avoid bull traps
Earning good returns in forex market is possible, but only if you get access to helpful trading tips. One of these tips is how to avoid getting entangled in a bull trap. What tricks can you use to escape this trap?
- Avoid emotions when executing trades
The biggest challenge for new investors in forex is setting aside emotions when making trades. Usually, there is a degree of apprehension that gnaws at you when you are about to enter the position. This tension will lead you to jumping at the first opportunity where you think the price action is reversing. Instead of such blind groping, you are better off relying on signals from forex expert advisors to determine entry and exit points during your trades.
- Do not panic!
Panicky decisions oftentimes end in disaster. Sometimes, it is prudent to hold back and watch what happens when the market looks like it is bottoming. Panicking might lead you to entering the market when the time is not right. If you want to be in this game for the long haul, then you must learn to steel your nerves.