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In falling markets, traders need to be on the lookout for what are called “Bull Traps.”
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A bull trap refers to a short-term rally during a downtrend that “traps” the bull who
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mistook it for the start of a new uptrend.
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As a matter of fact,
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some of the largest up days in history have occurred in during bear market cycles.
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Why does this happen? After a prolonged bull market, investors have been conditioned to
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“buy the dip.” After a sharp decline, “dip” buyers step in and the market starts
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to rise a bit. This initial rally then encourages other investors who think the worst is over
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and become fearful of missing out—creating a cycle of yet more buying. A temporary rise
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in prices may also force some short sellers to buy back shares to protect their profits,
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leading to even more buying.
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At some point, though, traders who held tight through the start of the downtrend will come
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to see this temporary rally as an opportunity to offload losing positions at a slightly
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better price. These sales, combined with short sellers re-establishing their short positions
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at the higher prices, may send stocks back into their pre-rally downtrend.
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So what does a “bull trap” actually look like? Here's a prime example from 2008.
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At the end of October, the S&P 500 had a large up day, which many traders took as a sign
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that the worst was over. But after a few more days of gains, peaking on November 4th, the
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sellers soon returned and pushed the market to even lower lows. The S&P 500 dropped
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25% from its November 4th closing high to its November 20th closing low. That's a
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massive amount of market damage in less than three weeks.
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So how do you know if you're looking at a potential bull trap? We'll cover that
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in the next video.