I got some questions on whether today's bearish action constituted a technical downside reversal
. The short answer is no, but it prompted me to pen this piece about chart patterns that fall under the general category of what I call bull or bear trap reversals. Before I get into that, there have been some recent technical signs of increased downside risk.
Leading into today's weakness, technical considerations suggesting that this market was quite vulnerable to a downside correction, included overbought extremes on indicators like the 13-day or even the 13-week Relative Strength Index (RSI). Moreover, bullish sentiment has been very high among options traders that likely reflected possibly unrealistic expectations about how long this market was going to resist normal selling pressures that tend to come in after a long upside run.
If there's further selling tomorrow and the next day, a key up trendline will get pierced in the Nasdaq 100 (NDX) and such a break would also suggest that an overall market correction was underway. Moreover, such things as a close or two below the 21-day (also, the 50-day) moving average would be a sign of still more downside potential.
My first chart highlights some of the aforementioned other chart considerations NOT relating to bull or bear trap reversals, which I will get into next.
One last note is about the RSI indicator seen above. It's interesting to note that the recent RSI extreme was very close to the prior RSI peak that occurred before NDX had a 'typical' down-up-down (a-b-c) correction of a 100+ points.
BULL and BEAR TRAP REVERSAL PATTERNS:
I may have heard the term elsewhere, but technical analyst Jack Schwager (and author of the "Market Wizard" books), during the time that we worked together at PaineWebber (now UBS) especially, drummed into me the terms bull and bear traps, describing, in the case of a bull trap, a rally that goes to a new high after which the advance then collapses. This was not the pattern seen in my first chart above. There was no new high today; there's most often a noticeable new high followed by a sharp sell off later in the day.
A bear trap is the reverse situation where a decline exceeds or takes out a prior low, usually decisively, followed immediately (same day or same week in the case of a weekly chart) by a strong rebound in prices.
Why the bull trap/bear trap terminology? Suppose the Nasdaq 100 today made a noticeable new high and then closed where it did. And where the index or stock then went on to fall substantially further (e.g., 100/100+ points). The bulls get 'trapped' so to speak as they #1) didn't see a sell off coming and, more importantly, #2) also don't believe that any substantial and sustained decline would develop.
In major bull trap reversals, as in 2000, many stocks went to new highs and then started to fall as the bull market basically started collapsing. It seemed almost that the bull 'trap' developed after the LAST bullish investors were lured into the market. There was this friend that I remember from that period who had ONLY ever invested in real estate but who finally bought some stocks, only to see them go down for the next year. This was an example of how even unlikely investors are eventually caught up in bull market fever.
From my historical chart database, my next chart of the S&P 100 (OEX) Index provided an example of a bear trap reversal as highlighted in my next chart.
The move to a new low seen in the OEX chart above, followed by a close ABOVE the prior day's HIGH also could be described as a 1-day key upside reversal, which is a move to new Low, followed by a Close that is ABOVE the prior day's HIGH. However, here I am describing a chart pattern that falls generally within what constitutes a bear trap reversal; i.e., a move to new low in a lengthily decline, followed by a strong rally the same day that's above or well above the prior day's close. Subsequent days then bring a continued strong advance.
Prices would not have to rebound to above the prior day's high to classify it as a bear trap reversal; just that there is a fairly rapid rebound after a new low is made and that the rally keeps going. After a time, 'confirmation' of a trend reversal is provided by other technical factors like a breakout above/below a significant trendline or channel which might include an upside or downside chart gap; both chart aspects are seen after the upside (bear trap) reversal seen above; i.e., there's both an upside chart gap and a breakout above a downtrend channel.
There are prior detailed articles within the Trader's Corner archive on both CHART GAPS and price CHANNELS.
I would emphasize that it's best to think of a bear or bull trap as applying to any time frame; e.g., on an hourly, daily, or weekly chart basis.
In a bull trap (downside) reversal, the rally that exceeds a prior high tends to bring in new buying because this so often signals a new up leg; i.e., another price swing of intermediate proportions. A new high serves to convince those long a stock or in calls, that they are on the right side of the market. If this rally then 'fails', by reversing to the downside, it has the effect of 'trapping' the bulls or those with the conviction that prices will keep rising. An historical example is shown in this weekly chart of McDonald's Corp. (MCD):
Another example is provided below in an hourly chart of the Nasdaq Composite (COMP) in August (2002). The collapse in COMP started in the next trading session, which was the next day. However, as the reversal occurred on the next bar, the downside reversal is also of the bull trap variety as the next bar is within an immediate or close by time frame; e.g., what happens in the next 'bar' or few bars.
You can find other examples in the same chart above of a move to new high followed by a pullback. So, how do you tell if a correction is temporary or a reversal of the trend? Often, the tip off is a related technical event like the break of a trendline or the downside chart gap also seen in the COMP hourly chart above.
You can find many examples of bull and bear traps in stocks and indices, often within the same chart. Examples of both Bear and Bull Trap reversals are seen in my next chart, which is also a weekly chart example with International Paper (IP).
In the case of the bear trap example below, after a sideways to lower trend had been underway for some time, there was a sharp fall which exceeds the prior weeks' lows by a comfortable margin. However, this time the lower low was followed by a rapid and good-sized advance. Renewed selling had no doubt come in as there was a move well below the prior (trading) range. Sellers, or buyers who had finally liquidated their positions, would have had expectations of another downswing or down leg.
In the example here with the weekly IP chart, many of the bears and short sellers could have been trapped by the rapid upside move. Of course, they are only 'trapped' as long as they don't cover any short stock or put positions. However, there's often a considerable period of disbelief that a trend reversal is actually occurring. To confirm a trend reversal technically, the index or stock should exceed its prior swing high or downswing low and prices could have some ways to go before this occurs.
Of course in the chart above, IP did manage to apparently break out of its trading range and the stock looked like it was going to perhaps see another substantial up leg. NOT! Instead the apparent breakout move to a new multimonth high was followed by a bear trap pattern, followed by a lengthily decline.
The lesson provided in the concept of bull and bear trap reversals of trend is that it pays to be leery of getting trapped in situations where prices correct sharply and reverse direction because you've become a total 'believer' in the prior trend.
There are implications of trend reversals of the type described here as bull and bear trap reversals, that go beyond affirming that market trends can reverse suddenly, even after exceeding prior lows and highs. Very often, such trend reversals after a prolonged trend can offer solid opportunities to take positions in the direction of the new trend as there's often potential for good-sized moves. Price moves often reach a point of exhaustion; e.g., the forces driving prices in the direction of the trend 'exhaust' themselves.
After almost everyone who is a potential buyer, or potential seller as the case may be, has bought or sold, there are few traders or investors not already in the stock or the market in general that can keep the trend going. In a downtrend, when there are few or no sellers left, only a modest amount of buying can drive prices back up sharply. When there are few or no buyers left, just a modest amount of selling can drive prices sharply lower. This is what is meant in the saying that "bull markets die of their own weight"; i.e., a market that has few people left that aren't already fully committed to stocks, can start falling simply due to the removal of new buying.
As seen in the examples provided and you can find more, these price swing 'failures' have a record of offering some major profit opportunities. If you are long puts for example, after a possible bear trap (upside) reversal and you don't want to reverse positions and buy calls or adopt other bullish strategies, you can at least exit at a point that protects some or most of your profit.
Moreover, I take this and every opportunity to caution against the intent to exit a position(s), versus actually having a index or stock price 'trigger' that you will definitely use to take action. For example, after an apparent bear trap reversal and where you hold puts, your exit point might be at a price that goes above the prior hourly or daily high. I always say to have a specific plan and not that you are going to 'watch' the market and make up your mind at some point.
After you get habituated to a trend and there is some unexpected strong reversal, the effect can be like a deer caught in the headlights; i.e., paralysis. I've been in that position enough times to know. Don't get caught up in a point of view so much as observing what the technical action of the market is telling you.
GOOD TRADING SUCCESS!