Stocks are Setting Up for a Bull Trap | Options Trading Strategies

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Stocks are Setting Up for a Bull Trap

The market looks like it may be setting up for a bull trap. These can be frustrating for long traders but are also an interesting opportunity. The bait for the trap has some common characteristics and right now we are seeing those play out on the major indexes including the Dow Jones Industrial Average and the Russell 2000.

A bull trap appears during a strong downtrend. A trend like that has been in play on the major stock indexes since 2nd quarter 2008 and has been escalating recently as investors deal with the credit crisis. The trap is baited by a strong move to the upside and an approach against resistance.

The nearly 900 point move on the Dow Jones Industrial Average on the 28th of October is exactly the kind of strong counter trend move we expect at the beginning of a bull trap. Bulls chase the big counter trend move to the upside and then subsequently get "trapped" when the market continues its downtrend.

Those bulls are trapped because they are typically chasing the big moves in the market and are buying at the top of the correction. Once the market starts to fall, these new bulls try to extricate themselves from the trap by selling. That selling pressure feeds back into the bear market and amplifies the subsequent move back to the downside.

The question of course is whether a given reversal is really a bull trap or a legitimate reversal to the upside. You can try to put the odds in your favor by looking for extreme moves like I illustrated on October 28th and a bump against a realistic resistance level. Those conditions are certainly met in this case.

Diamonds Trust (DIA)

However, rather than attempting to preempt the market by shorting or covering immediately you should typically wait for the market to begin rolling over to the downside. Many technicians suggest waiting until the market is below the close of the extreme counter trend move. You can see that benchmark level drawn on the chart of the popular Dow Jones Industrial Average ETF the Diamonds Trust (DIA) above.

Bull traps are not just an opportunity for swing traders looking for a trigger to short the market. They are useful for longer term traders as signal to apply some risk coverage to their long positions.