By Zak Mir of Zaks-TA.com*
Posted: Jun 12, 2009
One of the phenomena that many traders and investors try to avoid, and with good reason, is bear and bull traps. These can best be defined as brief breaks of support / resistance before the market returns to its existing range. The idea here is to actually take advantage of bull and bear traps after they have been identified so as to be one of the few who actually benefits from what can be powerful buy and sell signals.
The reason that this is the case is because the temporary breaks that traps represent are usually the result of stop losses being hit, thus causing an overshoot. The effect of this is to remove those from their positions who were actually correct in their view of where a stock or market was going.
A good example of this would be a bull trap on the June S&P (see previous chart). Here, it can be seen how there was a temporary break of the February intraday high of 869.75. The high in April at the point this screen shot was captured was 872. This was then the level to go short against in terms of trading against a "stop loss" overshoot high trap level.
Indeed, 872 was now a key level to trade against, with this market a sell into strength below it, and a likely-to-be-strong buy if it were to break. The buy would be regarded as all the more strong because it had effectively come in the wake of a double top break (February / April highs).
Of course, charting principles can be applied to almost any time frame, and it may have been that, for some, the hourly chart perspective of the price action around the June S&P's high was a better example than what could be seen on the daily chart.
What is interesting here is that we had the April 16 867 high to trade against in subsequent days. The price action of the following day delivered a 3-hour bull trap breakout through the 867 level, which some traders may have taken as a cue to go long.
However, an hourly close back below 867 -- the first one was at 866 two hours before the end of the session -- led to a setback as low as sub 830. In this instance, the risk was not much more than 5 points in order to make more than 30.
Something that tends to crop up in markets where sentiment is driven very strongly in one direction only, is traps in the opposite direction.
In Gold, where the metal had been hyped up to the stars, but had not yet delivered, we had a good example of countertrend bear traps. Not only did we see the bull run stall, but we could almost have set our watches by the bear traps that kicked in before every new rally attempt.
The position was a case in point where the second April low was $865.10, as opposed to $865.40 earlier in the month. There were two lower lows in March below the initial $900 low before the bounce through $960. To add to the misery of the longs, much of April's sub $900 price action simply looked to be a bear trap below March support of $884, something that may have been a hint of higher prices in the following month.
We were also looking to the future for the Pound / Dollar. What could be seen here from the daily chart was the way that, over the bulk of the December – April period, this market had been attempting to bull trap on highs, effectively stopping out the shorts just prior to a plunge in January 2009 from $1.50.
However, it could be that as little as a daily close back above the initial $1.46 April support could have led to at least a return to $1.50, thus signalling a change of trend. What helped was that the late April days below $1.46 were themselves narrow new bear trap lows, something that backed up the idea that, if $1.46 were first held and then $1.50 were cleared, we might then have expected to see quite an explosive upside move.
Of course, it would be difficult to finish off looking at bull / bear traps without looking at a financial giant, Citigroup (C), whose stock had been delivering such setups on a regular basis in the recent past.
The December 2008 plunge came after a bull trap through the last November high of $8.48, an overshoot of more than 50c. While there was not much you could do before such an event, once there had been an end-of-day close back below $8.48, you had your sell signal.
Another sell signal was given in April with the end-of-day close back below the last February high of $4.33, after the overshoot to $4.48. Indeed, after 4 months of trying, the $4 area began to look like a very solid wall of resistance -- traps or no traps.
*Reprinted (and modified) with permission from Zak Mir
