Here's how you can identify and avoid 'bull traps' while trading

Avdhut Bagkar | Business Standard
12th June

A 'bull trap' is a classic case of a false breakout. In general, buyers enter a trade with strong conviction of an upside. However, at times, the stock fails to deliver the upward move and instead hits the trader's stop loss or support levels. Such instances not only affect the trader's morale, but they also start to doubt their trading strategies. Every other triggered stop loss then induces “fear of uncertainty” in the trader and the feelings of “staying away” enters his/her system.

How to identify a bull trap?

Before entering into a trade, one needs to gauge the overall outlook of the stock market. If the trend is certain and upward, the trade you enter may not need extra caution. Trading with the trend also helps in building a strong “trading confidence”.

Moreover, one should have the knowledge of the sector or index from which you want to select a stock. In some cases, the market trend might be volatile, but some specific sector/ index may exhibit strong momentum. If the index outlook is positive, identifying a stock gets easier.

Avoid trading in stocks that are vulnerable to any corporate developments. Such situations exhibit uncertainty and potential volatility rise as the development starts to pour into the markets.

How to avoid a bull trap?

Once the stock breaks out, wait for the rally to sustain with decent volumes. Volatility in volume structure reflects uncertainty and indecision. It is better to hold nerves and let the price settle, keeping behind all the swings it has witnessed.

Make use of two – three technical / price indicators for a substantial confirmation. One can rely on a single indicator, however, having more than one indicator helps gauge the right momentum. That said, having more than three indicators can also create confusion. Thus, the ideal strategy should be to rely on limited technical indicators.

Indicators to track

Moving Averages: The major moving averages are 50-day moving average (DMA), 100-DMA and 200-DMA. While identifying a trade, list down stocks that are trading above these averages. Trading in stocks hovering below these averages increases the risk in terms of identifying strength, direction and momentum.

Chart Patterns / Candlestick patterns: Chart patterns like Inverse head and Shoulder, Double bottom, Falling channel pattern, Symmetrical triangle, and Ascending triangle assist in confirming a positive outlook. Candlestick patterns like Bullish engulfing, Morning Star, Piercing line, Three White soldiers, and Hammer are bullish indicators.

RSI, MACD: The two widely used indicators are Relative Strength Index (RSI) and Moving Average Convergence Divergence (MACD). RSI determines the strength in oversold and overbought conditions; also, crossovers determine the positive upside. Whereas, MACD facilitates in evaluating the underneath buying momentum, by identifying the direction on the zero line and crossovers.

One needs to develop strategies that provide confirmation based on the correlation of these indicators. A confirmed trade is said to have all these indicators giving a 'buy' signal. If any of the indicators isn't signalling a 'buy', it may increase the quantum of risk in a trade.

What to do when you fall in a bull trap?

The first response should be to exit the trade, rather than getting emotionally attached to the feeling of making profit. If one fails to exit, the loss may widen and even lead to a disastrous situation going ahead. (SEE BANKNIFTY weekly chart)

The price will tell you if it is a 'bull trap'. One way to identify a 'bull trap' is the swings with volatile volumes seen after the breakout levels. If the breakout is not a trap, then the price will show a consistent rise with closing above the previous high, at least for two – three sessions after the breakout neckline.

Disclaimer: This information is from a third party—Business Standard—offered through a tie-up to Kotak Securities customers. Click here for complete disclaimer.

The analysis has been done by a Business Standard reporter who is a certified technical analyst. The analysis does not represent the views of Kotak Securities.

A few links for further reading

Insecure and uncertain in insurance business as Covid-18 damage claims mount

Insurance companies around the world were sailing smoothly, helped by growth in emerging markets and strong capitalisation. Things changed in late February when markets realised that Covid-19’s impact on insurers could be significant. Insurers are yet to know the full impact of the crisis as governments and regulators nudge them to give moratoriums to policyholders and quickly settle claims too. India’s insurance regulator has set strict deadlines for medical insurers to settle Covid-19 claims. General insurers face damage claims from businesses devastated by the national lockdown to contain the disease. Is insurance secured to survive, Joydeep Ghosh explains

The unravelling

There was a time when pay cuts we see today were a complete no-no; govt and public sector jobs were considered safe, as pay and pensions were both assured. Not any longer, it seems, writes T N Ninan

Quick approval, grace period

The COVID-19 pandemic has brought home the significance of health and life insurance like nothing else earlier. Even those who were blasé about these covers in the past are now looking to buy a new policy or want to enhance the sum insured on their existing ones. Meanwhile, the Insurance Regulatory and Development Authority of India (IRDAI) has been issuing a slew of guidelines to health/general and life insurance companies aimed at easing matters for customers.

Want to get this in your email?