AIG Makes New Lows Following Bull Trap

Nov 25, 2007: 2:51 PM CST

AIG recently made new lows not seen since 2005, but what was significant was that the stock made a classic “Bull Trap” pattern which probably made the decline more severe than it should have been.

Bull traps occur when price seems to clear a major barrier or resistance area (such as a key moving average or prior high) and then immediately and forcefully sells off after triggering a “buy” signal (and subsequent positioning).

Bull traps are notorious for prolonging sell-swings and their unpredictability can wreck havoc on new trading accounts.

Notice how price had been beneath the 20, 50, and 200 period moving averages from July to September, and then cleared resistance above the 20 and 50 and actually found support at their convergence at the beginning of October. A brief ‘uptrend’ of higher price highs and higher price lows (swings) occurred and price cleared the overhanging (major resistance) from the flattened 200 period moving average.

The fact that price had accomplished this feat signaled a fair “all clear” sign to begin trading from the long side, and perhaps many traders or even funds did so at this critical juncture.

However, things would not be all clear for long. The price sliced through the 200 MA then found temporary support at the 20 before slicing definitively through it. Stops should have been placed below this level and executed immediately without hesitation.

As we know, new traders (and some major funds even) do not utilize or execute stop loss strategies, and in so doing, likely held through the eventual decline and probably sold (or are selling now) at significant and perhaps unexpected losses in AIG.

The pattern is the same across any stock. If a stock creates a popular or publicized “buy signal,” then the odds are that many traders see that signal and may act on it.

Should price not continue as expected, then those traders who bought at those levels will be forced to exit depending on their various methods of risk control (or lack thereof). This means that price will ebb quietly (or even violently) to the downside because the ‘head fake’ or bull trap pulled in a lot of transactions that must now be liquidated at lower and lower prices. The rampant selling will trigger selling from those who bought earlier as well and a vicious cycle can occur which will drive price beyond reasonable (or fundamental) levels.

Let’s look at the bigger picture in AIG:

In terms of the daily ‘bull trap,’ the weekly bull trap (buy signal) which also occurred as price broke above the 20 and 50 period moving averages, was ACTUALLY a bear flag pattern that set up a predictable “Measured Move” or “Lightning Bolt” pattern.

The weekly bear flag formed a textbook “wedge” pattern that, as expected, resolved to the downside.

While it was perfectly fine to take the ‘buy’ signal on either the daily chart or weekly chart, it is required to take the stop-loss that came after it rather than holding through it.

Of course, experienced traders could have executed an extremely high probability “short-sell” trade when they saw the failed buy signal as price reversed and completed the daily ‘head fake’ and broke the ‘wedge’ or ‘flag’ pattern on the weekly charts.

Always look at the larger picture when setting up your trades!

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