The Aussie market has had a strong run since the early July trough, with the recent peak in the S&P ASX 200 rising 18%. Traders are finally starting to take profits and appear to be heading for the exits as the deterioration in the global macro economic environment starts to bite. We are seeing a turn in the momentum for the ASX market near-term, and this has given rise to a number of bull traps being triggered.
Traders have been pushing stock prices higher since the Santa Claus rally materialised in November. Up until this week traders have chosen to ignore the global headwinds that have been simmering in the background, such as geopolitical tensions in the Korean Peninsular, political unrest and violence in the Middle East, the continuing issues of European sovereign debt in the so-called PIIGS economies, global concerns over food inflation, struggling consumer spending, and China’s struggle to control its runaway inflation.
Central banks around the world have been taking measures to address the economic issues including: the US Fed Reserve’s commitment to another round of quantitative easing (QE2); the ECB in Europe committing to support the indebted PIIGS economies; and in China the central bank has moved to raise the capital reserve requirements for its banks and increase rates in an attempt to reign in its inflation.
Traders have been looking for an excuse to take profits, and the violence and unrest in Egypt, Libya and the Middle East has provided the trigger to sell. The spike in the crude oil price has the potential to derail the global economic recovery, if energy prices remain at these elevated levels for any length of time.
A number of stocks in our local market have set up and/or triggered “bull traps” as they have recently backed off key levels. Traders have used this reporting season to reassess their view on particular stocks, and use any positive move in the stock resulting from their earnings report as a chance to liquidate part or all of their positions.
Bull Traps
A bull trap occurs when investors take on a long position when a stock is breaking out to new highs, only to have the stock reverse and shoot lower. This counter-move produces a trap for the bulls and often leads to sharp sell-offs.
The criteria for a bull trap set-up:
1. A prevailing long-term down
2. A sharp correction that has moved quickly from its lows
3. Resistance where investors look for price rejection setting up a long squeeze
The Bull Trap Set-Up
The bull trap set-up is fairly basic. Look for a trading range to be broken to the upside, preferably with high volume. The stock will need to get back below resistance within five trading periods, then explode out of the bottom of the range. The last component of the bull trap chart pattern is that the stock should have a wide price trading range. This increases the odds that the stock will have room to trend lower in order to book quick profits.
The Market Psychology of Bull Traps
Selling in the first wave will occur when the most recent swing low is exceeded. This occurs because of the number of shorter-term traders who have their stops slightly below the most recent swing low. The second wave of selling comes into play once the medium term traders realise that this is not just a slight retracement and the move is likely to be more protracted. This produces the second round of selling.
Bull Traps Trading Examples
There are a number of prime examples of recent bull traps, including Toll Holdings (TOL) in October, IAG Insurance (IAG) in December, Cochlear (COH) in January and WesFarmers (WES) in February.
Figure 1: Bull Trap – Toll Holdings (TOL) October 2010
Back in October Toll Holdings (TOL) broke to the upside to a 3-month high, but the bears then stepped in sending the price through the recent trading range within a few trading sessions, completing the bull trap. The volume did not provide confirmation for this trap but the selling continued with the stock dropping -20 percent in the following 3 months.
Figure 2: Bull Trap – IAG Insurance (IAG) December 2010
IAG Insurance (IAG) recently broke to the upside to a 4-month high in December, but the bears then stepped in sending the price through the recent trading range within a few trading sessions, completing the bull trap. The stock has dropped -11 percent in past couple of months. The sellers persisted until the stock broke the key trading range support and the bears appear to be firmly in control now.
Figure 3: Bull Trap – Cochlear (COH) January 2011
Cochlear (COH) recently broke to the upside to close at a 2-month high in January, then saw follow-through buying the next day as the bulls pushed the price higher. But then the bears stepped in, sending the price through the recent trading range within a few trading sessions, completing the bull trap. The stock has dropped -8 percent in the past month. The sellers have pushed the stock below its key support level and the bears appear to be in control.
Figure 4: Bull Trap – WesFarmers (WES) September 2010 and February 2011
WesFarmers (WES) recently broke to the upside trading at a 2-year high in February, then saw sharp pullback as the bears stepped in, sending the price through the recent trading range within a few trading sessions, completing the bull trap. The stock has dropped -5 percent in six trading sessions. The sellers have pushed the stock below a key support level and the bears appear to be in control at these levels.
The Market Analyser software offers Pre-Alerts which are proprietary indicators that identify impulses in volume accompanied by a decline (D) in price. As shown in the accompanying charts these Pre-Alerts, used in conjunction with the standard Bollinger Bands, are very accurate for identifying bull traps.
Conclusion
Bull traps can develop in markets where there is panic buying or overconfidence, as the stock prices move into key resistance levels. The bulls are trapped because they are typically chasing the big moves in the market and are buying new highs as the price meets resistance. Once the market starts to fall, these new bulls try to extract 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. The way to trade these set-ups is rather than attempting to pre-empt the market by shorting or covering immediately, you should typically wait for the market to begin rolling over to the downside.
Use the Market Analyser’s proprietary Pre-Alert Distribution Indicator to identify when a setup is imminent (refer to the sample charts for examples).
A change in market momentum and sentiment appear to be underway and bull traps are not just an opportunity for swing traders looking for a trigger to trade the short side of the market. They are useful for longer term traders as a signal to apply some risk coverage to their long positions, either through hedging their positions or stepping to the sidelines.
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By Micheal Hevern
Head of Research
