In the previous video, we learned about bull traps, or temporary rallies that can appear during a downtrend, luring overly-optimistic traders back to the market, only to frustrate them when the downtrend returns.
So how do you know if you’re looking at a potential bull trap?
Some traders use a technical tool called the "Fibonacci Retracement Trend” line. Markets tend not to move straight up or down; instead they often retrace a portion of their last move before a trend reasserts itself. Those retracements often occur in ratios first established by a 13th century mathematician named Leonardo de Pisa, nicknamed Fibonacci.
You can create Fibonacci retracement lines by choosing a major peak and trough on a stock chart. The tool creates horizontal lines at key Fibonacci ratios--23.6%, 38.2%, 50%, and 61.8% of the distance between the peak and the trough. You can then use these lines to identify possible support and resistance levels.
Let’s look at a key example using the S&P 500 index. We’re looking specifically at the period between October 11, 2007 and October 2008 to highlight the peak-to-trough move. Here we see that the price touches matching lows about two and a half weeks apart, which some traders see as a signal that the short-term bottom may have been reached and might not be retested again.
However, by overlaying the Fibonacci retracement tool on the price action, we can see that the price encountered resistance at the 23.6% level after the second bounce.
Savvy traders might wait for the price to break through this level and hold for a day or two before entering a position. If we take the chart forward, we can see how their patience would have been rewarded: Had a trader chosen to start a new position on November 4th, 2008, they’d have been forced to wait until August of 2009 before that purchase was profitable. Because what happened next? The S&P 500 hit a new short-term bottom near $740. A new bottom calls for a re-drawing of the Fibonacci retracement levels. The bounce off this $740 level rallied again into the 23.6% retracement level before retreating lower, eventually marking the absolute bottom in March 2009. It eventually retraced, and held, the 23.6% level before establishing a new short-term uptrend. We can then add the 50-day simple moving average to confirm that upward move. So in this example, using Fibonacci retracement levels and then moving averages could have helped to identify a bull trap in late 2008 and a buying opportunity in early 2009.
Of course, this isn’t to imply that Fibonacci tools are infallible. As with any technical tool, the goal is for traders to test convictions and then appropriately set their risk levels. Make sure to watch our other videos on technical indicators and subscribe to our You Tube channel.