Stocks Are Setting Up For a Bull Trap
by John Jagerson 11/05/08
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 (DJI) and the Russell 2000 (RUT).
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A bull trap appears during a strong downtrend. A trend like that has been in play on the major stock indexes since second quarter of 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 on Oct. 28 is exactly the kind of strong countertrend move we expect at the beginning of a bull trap. Bulls chase the big countertrend move to the upside and then subsequently get "trapped" when the market continues its downtrend.
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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 Oct. 28, and a bump against a realistic resistance level. Those conditions are certainly met in this case.
