How to Recognize a Bull Trap

Listen carefully. Can you hear the snap? The sharpest daily surge in the Dow since 1932 will hopefully prove me wrong, although I doubt it.

It usually happens eventually, a strong (very strong) green day after a stormy streak of bright red days that surprised even the most pessimistic individuals. It just couldn't get any lower than this, could it?

Headlines everywhere quickly take comfort in the stock market rebound praising government intervention, the ingenious true fundamental investors and everything else that comes to mind. We did say manic-depressive at least a couple of times, haven't we?

As my readers probably know by now I usually feel more comfortable outside the herd. As such, I feel I have the responsibility to share other points of view. In this post I will discuss the (probable) possibility anyone hoping to ride any short-term up-trend amidst a bloody ocean of butchered stocks may very well find himself in the firm grasp of the infamous bull trap. I've also found interesting contradicting evidence which I will point out.

According to Investopedia a bull trap is "a false signal indicating that a declining trend in a stock or index has reversed and is heading upwards when, in fact, the security will continue to decline."

What Do Bull Traps Feel Like?

#1 There's supposed to be a period of treading in place

When you apply common sense to it you quickly understand markets don't simply reverse the trend just like that. Fundamentals and expectations need time and reasons to change. No government plan can really impact the market in a matter of days.

The market naturally moves in trends and reflects the group thinking of investors. Since market players are human as well I tend to believe markets reflect human psychology and as such move in distinct trends.

Before a choice of reversal is made a period of treading in place, hesitantly, often takes place. Some market players believe the recent change in trend maybe a good opportunity to buy while others think it's a good time to get rid of more stocks.

I find it very hard to believe the stock market suddenly reverses a trend in the way schools of fish or flocks of birds do.

#2 Corrections are to be expected

Corrections are to be expected when the market shifts violently in either direction. When we look at stock market charts these are quite visible and very common as market players test the environment and realize both profits and losses.

These corrections are comprised of various effects which ultimately add up to form either a bull or bear trap in a certain general trend. For example:

• Short players are probably realizing the profits and taking a breather before plunging back in.
• Fundamental investors are taking advantage of low stock prices and are buying another share of their favorite companies.
  
  

#3 After the manic the depressive will reappear

Even in times of crisis, good news find may their way to the financial headlines. In the current crisis we've had massive government interventions, $700 billion bailout plans, banking industry bailout, liquidity poured on markets like water, joint worldwide interest rate cuts and so far nothing.

Someone decided, that if the stock market is painted green something must be working and their choosing a headline accordingly: "government pledges bank aid; Dow jumps more than 900 points". A +11% move is awesome indeed.

What happened? Where'd all the depression go? Suddenly central banks have enough money and tools to solve the crisis in a day? One might say the crisis was uncalled for, and reason is back in the markets. I do hope that is the case but somehow I doubt it.

The less probable scenario

It just might be that our problems are solved. If central banks provide a solid foundation of liquidity and guarantees banks may feel comfortable to lend again and the wheels of the market will grind back to work.

Perhaps this was (rather than is) a financial markets crisis which the real economy suffered little from. I lack the experience to tell. Somehow I believe the previous scenario I painted is much more probable.

I promised contradicting evidence. In a post titled 10 Bullish Charts, Signals, Indicators @ The Big Picture very interesting evidence is brought forth to substantiate the claim the market has hit its low. One word of caution is in place, there are always some indicators which indicate exactly what you're looking for. It's very important to judge them for yourself.

Related Posts:

• From a Financial Crisis to a Real Crisis: The Makings of a Greek Tragedy?
• The Credit Crisis Presents a Rare Opportunity for Learning and Experience
• Extreme Risk Aversion Paradoxically Leads to Another Huge Risk
• How to Invest Wisely In a Bear Market?
• The Relation between Age and Portfolio Risk – Counter Intuitive Results

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