Daily Brief - What is a sucker rally?

We are in a bear market. Duh. Historically, stock prices are in a rising trend over 75% of the time so for many investors, a downtrend is a relatively new experience. Even for veteran traders, bear markets are a tough environment to invest in. For novices, it might be downright treacherous. Bull traps are one reason bear markets can be so challenging.

A sucker rally

It goes like this. Market sells off. A lot. So, you go long. And the price moves in your favor (a little). But just as you’re patting yourself on the back, the market does a 180-degree reversal and BOOM, you get stopped out.

More formally, a bull trap is when a market that is on a downtrend experiences a brief increase in value. Investors, aiming to buy when prices are low, begin purchasing shares, boosting prices briefly. After the brief increase in price, the market reverses direction again, returning to its downward trend and falling even more, usually below the level it was at when the bull trap began.

The alternative name for a bull trap? A sucker rally.

The mechanics of a bull trap

Why do bull traps happen? It’s entirely Pavlovian. Investors are conditioned to buy dips. After steep declines, there’s often clamoring among investors to grab an early seat for the ride back up, and get in at what appears to be a bargain price.

The demand from those investors, along with short sellers buying back their shares, helps fuel an increase in the stock’s price.

This can often push prices above certain chart levels, and these “breakouts” can trigger more buying as breakout buyers join the “buy the dip” crowd. Look at the chart of SPX so far this year: we just lived through such an example.

How to spot a bull trap

There are a few key indicators to watch that will help you avoid the suckers’ rally. Here’s what you’ll often see in a bull trap:

1. Low trade volume - for a true market bottom you should see weaker volume on sell-off and high volume on rises. Bull trap is often exactly the opposite as there are still more investors keen to get out than get into the stock
2. Failure to rise above its key moving averages - a stock might rise over the very short term moving average but fails to clear some longer term ones (50- or 200-day) that previously acted as support.
3. No confirmation from a technical oscillator - indicators like Relative Strength Index (RSI) help identify so-called overbought/oversold conditions
4. Parabolic rise - a combination of short-covering and false breakouts can give rise to an unsustainable spike that doesn’t have any obvious support to re-test the rally on
5. Failure to clear resistance - prices may often strongly with even very weakly established resistance on the top side
6. Unusually huge candlestick - These often arise as initial dip buying leads to short covering and a quick rise. A breakout finally draws in manic buyers convinced that resistance has been cleared and they have a well-defined stop level (the broken resistance point) they can trade with.

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