The Art Of The Bull Trap

The lesson examines the art of playing the "bull trap." This situation occurs when the price of a stock moves above a resistance line, triggering buy signals, but then quickly reverses course, "trapping" with losses those who went long. These situations can occur on all time frames, and with all patterns that have a resistance lines.

The examples I picked for this lesson are taken from the intermediate-term perspective. In bad markets like the one we've been having, failed breakouts are a common thing. Ideally, we look for a breakout as an opportunity to go long with a stop loss set at 7% to 8% below a buy point -- though when the stock breaks out, then suddenly sells off back into its base, it can often be setting up a profitable swing trade to the short side.

The strategy I am going to discuss is for the more nimble and aggressive trader. Intermediate-term trading and swing trading can seem worlds apart when it comes to interpreting information and making decisions. The level of risk for going short is often higher than the long side, and the time frame here can be very short. Keep in mind it is always a good idea to go into a trade with an idea of what you want out of it, and always have a stop loss pre-programmed.

Harley Davidson (HDI | Quote | Chart | News | PowerRating)

In the example with Harley Davidson (HDI | Quote | Chart | News | PowerRating) above, the stock built a six-month base, formed a handle, then finally broke through the resistance line at 52.51. On the second day after the breakout, the stock plummetted, creating a "bull trap" for those who bought the breakout. The third day after the breakout saw further selling pressure.

An ideal entry into this setup would have been where the price began to go lower than its breakout. Taking a position at the end of the second day after the breakout appeared to be ideal, as heavy selling accompanied the move. Covering a short position on this one was a tough call. The obvious signs of downward pressure in the high-volume bars reversing the breakout were a good indication that the stock's path of least resistance was to the downside, and depending on your own tolerance, a profit of a couple of points and a quick exit may have suited you fine.

A closer look at this stock shows signs as to why the breakout may have failed. In analyzing the handle, we can see that the volume on the down days, for the most part, exceeded that of the up days. This suggested that a breakout might not be as well supported. The volume for its breakout was 39% above its average daily volume, and just shy of the 40% intermediate players use as a minimum for a breakout. To further add to why the stock may have failed, it didn't make our IT Report because its revenue was below 20% for the last two quarters. The company also recently made the cover of Forbes Magazine as "Company of the Year," an often punishing reward for a company's stock.

THQ Inc. (THQI | Quote | Chart | News | PowerRating)

In the example above, we have THQ Inc. (THQI | Quote | Chart | News | PowerRating) as it came out of a month-long base. The breakout looked good as it cruised above its resistance line on high volume, but was foiled when a complete reversal of the price action erased the gains with even higher volume. This action created another "bull trap," and also marked a new downtrend for the stock.

A nimble trader watching this action may have entered a short position at the close on the day after the stock broke out. At this point, traders who took the breakout were panicking because they had an immediate loss. A short entry here would have netted a few points in the next couple of days, and depending on stop-loss tolerance, you may have held out for even further profits. Another way to play this is to recognize that the stock failed to carry through on a breakout, then look for clues in the following sessions for signs of the stock topping out.

Early warning for this action may have been provided by the fact that the stock showed some significant selling pressure in the days preceding the breakout (note the high volume down days.) Another sign of weakness was that this stock was in a bad market and a member of a weak industry group.

Integra Life Sciences (IART | Quote | Chart | News | PowerRating)

Here we have Integra LifeSciences Corp. (IART | Quote | Chart | News | PowerRating) as it broke out of a three-month base on over 70% of its daily average volume. The next day the stock shot even higher, though eventually succumbed to a sell off that took out all the gains made on the breakout. This is exactly what someone going long on a breakout does not want to see.

As with the examples above, a way to take this is to go short once the breakout gains were reversed. A short position taken at the close, the day after the breakout, would have been good for at least a couple points in three days. Not bad considering how much you would have made going long on the breakout. The chart for this one also shows how taking a quick profit is a good idea with these set ups. After going down for three days, this one put in a trend reversal and eventually sailed to levels above its breakout point. For the record, intermediate-term players would have been stopped out of this one when the stock went 7%-8% below a pivot buy point of 32.30.

Unlike the previous examples, this stock had a lot of things going for it. It met the strict criteria of fundamentals and technicals to be an intermediate-term selection, had a nice long base, and was showing signs of accumulation into the breakout. On a negative note, it was in a bad market and didn't have a healthy handle with a shakeout. So what made this one fall apart? Who knows. In this business it's important to be able to recognize a high-probability set up and take a swing. The cue here was the reversal the day after the breakout.

Direct Focus Inc  (DFXI | Quote | Chart | News | PowerRating)

On this breakout with Direct Focus Inc. (DFXI | Quote | Chart | News | PowerRating), no signals were given to create a "bull trap" or even go short. The stock broke out on over six times average volume, though failed to move up until a couple of weeks later. Despite the price action dropping below the breakout zone, no sell signals were triggered on the daily bars, nor marked by distribution. In an ideal "bull trap" we want to see the action happen quickly to create a panic for buyers. This stock was another intermediate-term candidate, though it didn't last long before triggering an 8% stop loss. The above example is given to compare with for what not to take as a "bull trap" set up.

Summary

To sum up, "bull traps" are an aggressive way to turn a quick profit off of a failed breakout. Those who examine breakouts closely have probably noticed this pattern occurring quite a bit in this market. These situations aren't the easiest to predict, and they're more of a reactionary move, but it pays to do your homework. You can keep an eye on potential candidates through our Cup and Handles list, or Stocks Building a Base list. Also be sure to check out our lesson on handles, as the clues for a stocks success can often be found in this portion of a pattern.

Best of luck,

Daniel

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