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What Is a Bull Trap?

Geri Terzo
Geri Terzo

Investors, including sophisticated individuals and institutions in addition to beginners, often look to market trends that unfold in financial securities before making buy or sell decisions. For instance, when there appears to be downward momentum in a stock price, conditions might be appropriate for a buying opportunity. Conversely, a soaring stock price might be an indication that a stock is nearing its potential, which could reflect a selling opportunity. When a stock that has been on a downward slide begins to reverse course and show signs of strength, investors might pile on and buy the stock. A bull trap is when those signs of increase were an aberration, the stock returns to its declines, and investors are subsequently trapped in the exposure.

Professional market technicians are in the habit of looking to investment trends to assess a stock's potential. Historical price movements are highly influential in the way that technicians and other investment professionals predict future stock performance. Money managers often apply investment strategies based on the price movement of a particular stock security, or changes that often suggest a stock is being undervalued or overvalued by investors and therefore presents an opportunity. In a bull trap, investors are falsely lured to believe that a stock's recent plight has been rectified only to learn that the upward momentum that was anticipated fails to profit these investors.

Man climbing a rope
Man climbing a rope

Incidentally, there are ways to capitalize on a bull trap. Market technicians use charts and graphs to determine when stocks have reached a peak or trough. In some cases, selling a stock or going short on that security, which is a bet that the price will decline, is recommended after an investment has hit its peak, or resistance level, and begins to retreat. A stock's resistance level can be determined by using charts and graphs illustrating price movements over a period of time. Professional hedge fund managers are involved with investment shorting techniques and may profit from a bull trap.

There are different influences that can create a situation in the markets where a stock presents a bull trap. Investors often trade on emotions, including euphoria and fear. If there is some external event in the local or global economy that causes investors to celebrate, that enthusiasm for buying stocks may be short-lived. Subsequently, when current investors are faced only with the fundamental picture at a particular company, there may be more reasons to sell the investment than to hold onto it.

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