“Investing or trading in stock markets is a high risk activity. Those who cannot afford to risk their money should refrain from dealing in stocks.”
This may be called a standard clause in any disclosure, but there is a reason behind it.
Technical analysis, like any other science, has some limitations. One good example will be the weather forecast. “The chances of precipitation is 40%” may be the forecast, if it doesn’t rain, the meteorological department can’t be blamed.
Similarly the technical analyst can’t be held if things turn the other way around.
We shall discuss about classic stock market “traps”. To understand this easily, a little bit of introduction to Elliot wave theory is essential.
Ralph Nelson Elliot believed that price movement of stocks could be predicted by observing and identifying a repetitive pattern of waves. He thought that “action” is followed by reaction. There are five waves in the direction of the main trend followed by three corrective waves (a "5-3" move).
The underlying 5-3 pattern remains constant, though the time span of each may vary. The basic pattern is made up of eight waves (five up and three down) which are labeled 1, 2, 3, 4, 5, a, b, and c on the chart. Waves 1, 3, and 5 are called impulse waves. Waves 2 and 4 are called corrective waves. Waves a, b, and c correct the main trend made by waves 1 through 5.
Technically, a “buy” signal will be generated when the high of wave 1 is breached by wave 3. Similarly, when high of wave 3 is breached by wave 5 we get a buy signal. During a downtrend when the low of a particular wave is broken, we get a “sell” signal. This is the normal chart pattern and reliable trading strategy.
What can go wrong with this strategy? First let us see the bull trap.
Bull trap:
Sometimes a stock may break its important resistance zone and create a buy signal as disussed earlier. However, it may fall back again back to its support levels instead of going up further. Those who entered into the trade after the breakout will be stranded as the stock keeps falling.
As the stock breaks resistance, many traders may add to their exisiting long positions or create new long positions. Those who were short on the market will be forced to cover up their positions. The bears, however, may sell huge amount of stock at this level to force the price back to its supports. The supply for the stock may overcome its demand, so the fall becomes very quick. Those traders without an exit strategy will find themselves at big losses in the long positions. In such a situation, a “stop loss” strategy or an acceptable loss will minimize the risk to the bulls.
Let us see the daily chart of Bharat Earth Movers Limited (BEML) last year.
The stock fell from a high of 1080 on 14.07.06 to a low of 790.05 on 26.07.06. Then an uptrend started. It reached a high of 1055. Again a corrective decline started to a form a low at 868. In other words, a higher low has been formed on this occasion.
The stock broke the resistance at 1080 on 27.10.06. However, it didn’t last long. After six trading sessions, stock fell to 1077, or below its previous resistance. It continued to fall and even broke its support trendline. The upmove followed after that was shortlived; once again the bears were in action. The stock came down to a low of 885 or almost the previous support. Those who entered after the breakout were left with losses in their trading accounts. This is a classic “bull trap”.
Bear Trap:
This is simply the reverse of the bull trap. When the stock breaks an important support level, traders get a sell signal. Traders may intiate fresh short positions or may add to their existing short positions. However, the bulls push the stock vigurously by aggressive buying. The stock breaks the previous resistance and goes up higher. As a result the bears find themselves to be the losers.
Bear trap can often lead to a big upward move due to the number of buyers attempting to buy the stock. Some buyers will see a big surge in volume and get attracted to the potential for quick profits, which helps deplete any supply quicker. Some others see that the short sellers are in trouble, they will enter the market and buy as much stock as they can to produce losses for the short sellers. Once the shorts have a position moving against them, they become overrun by fear and start to buy back their shares quickly to limit their losses.
Let us examine the daily chart of Indian Petrochemical Corporation Limited (IPCL) below:
Conclusion:
Bull and bear traps can be found on a fairly regular basis on daily charts. These false patterns are important to short term investors because because the profits that follow can be large and quick.