When buying into what appears to be a great stock breaking out of a base to claim higher highs there is nothing more frustrating then seeing your investment turn from promising to junk in a matter of days. As an investor you thought you had a potential winner on your end, but the stock falls off after the “breakout”.
Congratulations, you were victimized by a bull trap.
Bull and bear traps alike are commonly seen and can be very hard to avoid. Whether you are a seasoned market veteran or a new trader, dodging these tricky traps is no easy task.
The most common form of a bull trap occurs when a stock breaks higher, most often to several week or several month highs, then almost immediately reverses back into its base and sells off over the next week or longer. It is a hidden trap as numerous buy orders trigger when the stock breaks higher and these investors are subsequently stuck with a losing position as institutional investors sell into the strength and take profits.
These occurrences are tormenting psychologically and, well, overall they just plain stink. Below are several recent examples using Amazon (AMZN), Green Mountain Coffee Roasters (GMCR), and Cepheid (CPHD).
Luckily for investors, bull trap effects can be minimized or avoided altogether. Here are five tips for handling these destructive traps:
1. Use stop losses – Stop loss orders are a great way to avoid having a small loss turn into a large hit to your portfolio. Acting like insurance, a stop loss triggers at whatever predetermined price you set, as a result automatically selling your position (See also 10 Stop Loss Order Tips for Success).
2. Know your patterns – In William O’Neil’s best seller How to Make Money in Stocks he breaks down several common technical patterns and describes the importance of understanding how they form so you do not buy into a dud. For example, breakouts often lack proper volume expansion or occur too quickly without giving the stock enough time to base out. This can cause their demise.
3. Monitor the market – It is a known fact that 75% of stocks follow the overall market trend. Trading against the trend is a clear cut way to greatly reduce your chances of success regardless if you are buying into higher highs or buying on value. Fortunately, market recaps take place daily here at StockTradingToGo.
4. Use proper position sizing – Often times it is unwise to buy a full position at first. Instead, consider buying say 50% first and the other 50% over a second purchase or split into two other purchases (25%, 25%) as the stock moves up in price. This lowers initial risk and allows you to buy on affirmed strength.
5. Experience is your friend – Always conduct post-trade analysis and learn from every investment. Long term this is your best defense against bull traps or any other trap that is out there to take advantage of your precious portfolio. The wise and experienced investor wins over the long haul, not the short term.
Stay frosty (sharp) out there! 😎