The global markets have had a strong run since the late September, and we saw euphoric buying last week after the EU summit announcements that they will be delivering on their “comprehensive” bailout plan, with private investors taking a “voluntary” 50% write-down on sovereign Greek bonds, the size of the eurozone EFSF bailout fund will be increased to EUR1 trillion, and Greece will aim to reduce its debt to 120% of gross domestic product (GDP) by 2020.
Traders have been pushing stock prices higher since the “comprehensive” bailout plan was first mentioned in late September. However we have seen a turn in the momentum for the ASX market near-term, and this has given rise to a potential bull trap being triggered.
The S&P ASX 200 has risen over 15% from its recent low to high, but traders are starting to take profits and appear to be heading for the exits in the short term. Investors are showing some concern over the implementation strategy for the EU “comprehensive” bailout plan.
In the case for the bulls the Central banks around in the eurozone have been taking measures to address the economic debt crisis and the US Fed Reserve announced “operation twist” and is rumoured to be considering QE3 for some time early next year.
However up until this week, traders have chosen to ignore the rumblings over how difficult and protracted the solution for the eurozone debt crisis resolution will be, plus the implications of a slowing Chinese economy in relation to demand and commodity prices, and the corresponding impact on resource company earnings going forward.
A number of markets globally have set up and/or triggered “bull traps” as they have recently backed off key resistance levels. Traders have been looking for an excuse to take profits, and the resurfacing of concerns over the implementation issues over the EU “comprehensive” bailout plan appears to be a catalyst at least in the short-term. Also there are concerns raised by the fallout over bankruptcy the of the world’s leading futures and derivatives broker, MF Global.
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 the ASX, the S&P500 and the German DAX.
Figure 1: Bull Trap – S&P/ASX 200 (XJO) November 2011
Last week the S&P/ASX 200 broke to the upside to a 3-month high, after having risen over 18 percent in the past month. However the bears then stepped in sending the price through the test the lower band of 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 -8 percent in the following 3 sessions. If the market falls through the current support level, then a retest of the recent lows is possible, while a breakout above the recent highs will signal a resumption of the up-move.
Figure 2: Bull Trap – S&P 500 (.SPX) November 2011
The S&P 500 (.SPX) recently broke to the upside to a 3-month high last week, after having risen over 20 percent in the past month. The bears have stepped in sending the price through the recent uptrend within a few trading sessions. If the selling continues a bull trap will be confirmed. The stock has dropped over -5 percent in past couple sessions. If the sellers persist we would expect the US market to fall back into the 3-month trading range. If the market falls through the current support level then a retest of the recent lows is possible, while a breakout above the recent highs will signal a resumption of the up-move.
Figure 3: Bull Trap – German DAX (.GDAXI) November 2011
German DAX (.GDAXI) recently broke to the upside to close at a 3-month high last week, after having risen over 29 percent in the past month. Then we 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 uptrend within a few trading sessions. If the selling continues a bull trap will be confirmed. The stock has dropped -10 percent in the past few sessions. If the sellers persist we would expect the market to fall back into the 3-month trading range. If the market falls through the current support level then a retest of the recent lows is possible, while a breakout above the recent highs will signal a resumption of the up-move.
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.
Options are an ideal way to protect your position(s) and/or take advantage of the current market environment, because they allow you to trade with a defined risk. MDS Financial Advisory Services offers general advice on trading options to generate consistent steady income on your investment portfolio. Call 1300 610 024 and ask for me for further information.
By Micheal Hevern
Investment Adviser
MDS Trading Desk
