A bear trap occurs when institutional traders prey on less experienced retail investors to provide market liquidity.
A trader who has fallen into a bear trap finds himself in the red, then the stop-losses of unprofitable trades are triggered, which is the fuel for the development of a bullish trend.
How Does A Bear Trap Work?
A bear trap in financial markets refers to a period of time when a particular instrument breaks through a key support level and then reverses, thus recovering lost positions. A break through a support level can be just as sharp as a reversal.
However, a situation may arise in the market when the asset remains below support for some time, luring traders into a bear trap and forming a reversal.
A bear trap is a frequent occurrence. The reason is that bulls dominate the balance of power. This means that there is a situation in the market when there are more people who want to buy a financial instrument than there are people who want to sell it.
This leads to price gouging by buyers who want to attract more sellers to the market.
ALSO CHECK: Bull Trap: Definition and how to avoid getting into one
Bear Trap Example
For example, if you short sold 50 shares of XYZ and they are now trading at $40, you owe your broker $2,000 ($50 x $40). If XYZ rose to $50, you would owe your broker $2,500 ($50 x $50).
In the above example, if you shorted XYZ and the stock is currently at $50, you would need at least $15 in your account for each stock you short. If XYZ goes up to $100, you’ll need $30 in your account for each share you shorted.
A bear trap is triggered when the price of the stock you shorted rises to such a level that you no longer meet your broker’s capital requirements relative to the number of shares you shorted. When this happens, you will receive a margin call.
You will either have to immediately close the short position (taking a loss) or contribute additional money. If prices continue to rise, you’ll have to keep cashing in or accept even bigger losses.
ALSO CHECK: BUY TO CLOSE: Definition And Trading Guide
What Are The Causes Of Bear Traps?
What triggers a bear trap is not just a downward price movement, but a price drop below a key support level.
A bearish investor or trader expects a downward breakout through a resistance level, followed by a further downward movement. Thus, they fall into the “trap” and lose money after the price reverses back up. The reasons for the appearance of a trap are:
- A price drop below a key support level
- An investor or trader opens a short position
- The fall below the support level is short and is accompanied by an upward reversal of the price
ALSO CHECK: BUY TO OPEN VS BUY TO CLOSE: What are the Options?
When Do Bear Traps Occur?
Institutions buy stocks at wholesale prices, usually after they fall. This will lead to a reversal of downward trends and rising markets. This is the best time to buy, but many amateur and novice investors and traders wait and buy when they see prices already rising.
Even worse, many people are taught to buy breakouts and chase the price when it rises. This is a signal to institutions that it may be time to set a trap on the stock. When you see volume increase accompanying a price breakout, a bear trap is usually just around the corner.
ALSO CHECK: DELTA HEDGING: What Are The Options?
What Is Bear Trap Trading?
Bear trap trading is often used by experienced traders for shorting or short selling – the process of selling an asset at a high price and then buying it back at a lower price for a profit.
There are many ways to do a short sale; for example, you can borrow shares from a broker on margin. Using this strategy, you can sell your shares at the current market value and then buy them back at a lower price from your broker when the market falls.
When prices fall sharply in an uptrend, a bear trap follows. This phenomenon and market indicators motivate many traders to invest and buy in the market.
Most traders usually do not know how to trade bear traps or when they fall into a trap. A bear trap trade occurs when a trader, attracted by falling prices, decides to open a short position when a currency pair is falling, only for the price to reverse and suddenly go up and move higher.
ALSO CHECK: SELL TO OPEN VS SELL TO CLOSE: Detailed Comparison
How Does It Work?
Usually, other traders set up bear traps where they sell assets until other traders are convinced that the uptrend is over and prices will fall.
As prices continue to fall, traders will be fooled into believing that this will continue.
And then the bear trap will be released when the market changes and prices rise. This is a false market efficiency that causes many traders to lose money.
Types Of Bear Trap Chart Patterns
When a bear trap occurs, there is usually a false breakout of a support level, the purpose of which is to trap as many traders as possible. Below we will consider popular types of bear trap patterns.
Collapse In The Gap
We can see this type of bear trap on the stock chart of Apple Inc. The breakthrough of the support level was accompanied by the formation of a gap and the formation of a bullish candlestick pattern of hammers.
This is the collapse of the candle in the gap. The price bounce above the support level confirmed that the bulls are holding this mark.
In addition, the growth of quotations was preceded by the formation of a bullish divergence on the RSI technical indicator, which signaled in advance a reversal of the trend and an impending bear trap.
Pin Bar Squeeze
This pattern is often found in all types of financial instruments. Below is an illustration of a pin bar squeeze on the BTC/USD chart. The initial signal for a reversal was also the bullish divergence of the MACD indicator.
The crossing point of the moving average initiated a new growth of the instrument. In candlestick analysis, a squeeze is accompanied by the formation of an up or down candlestick shadow.
In the current situation, the formation of a series of bullish hammer patterns became confirmation of future growth.
What Is Reverse Bear Trap?
A bear trap can lead a market participant to expect a decline in the value of a financial instrument, prompting them to execute a short position on the asset.
However, in this scenario, the value of the asset remains unchanged or increases, and the participant is forced to suffer a loss.
A bullish trader may sell a declining asset to lock in profits, while a bearish trader may try to short the asset to buy it back after the price has fallen to a certain level. If this downtrend never occurs or reverses after a short period, the price reversal is defined as a bear trap.
How To Recognize And Avoid A Bear Trap
In most cases, spotting a bear trap requires the use of trading indicators and technical analysis tools such as RSI, Fibonacci levels and volume indicators, and these will likely confirm whether a trend reversal after a period of sustained upward price movement is genuine or simply meant to invite shorts.
Any downtrend should be driven by high trading volumes to rule out the possibility of a bear trap. Generally speaking, a combination of factors, including price pulling back just below a key support level, failure to close below critical Fibonacci levels, and low volume, are signs of a bear trap forming.
Crypto investors with a low risk appetite are best advised to avoid trading during sharp and unwarranted price reversals unless price and volume confirm a trend reversal below an important support level.
During such periods, it makes sense to hold cryptocurrency and avoid selling unless prices have exceeded the initial purchase price or stop loss level. It is useful to understand how cryptocurrencies and the entire crypto market react to news, sentiment or even crowd psychology.
Practicing this can be a lot more difficult than it seems, especially when you take into account the high volatility associated with most cryptocurrencies traded today.
On the other hand, if you want to profit from a momentum reversal, it is better to choose a put option rather than short selling or becoming long sellers of the underlying cryptocurrency.
This is because selling short or selling calls can expose the trader to unlimited risk if the cryptocurrency resumes its uptrend, which does not happen if you choose a put position.
Conclusion
Individual investors do not need to worry about bear traps unless they are investing on margin and betting against the market or individual stocks. If you are betting against stocks, you should watch out for bear traps.
One way to stop bear traps is to avoid short positions with large or infinite liability potential. For example, instead of short selling a stock, you can buy put options. With an option, you will profit if the stock price falls, but your maximum loss is equal to the premium you paid for the option.
Bear Trap FAQs
What Does A Bear Trap Mean For Individual Investors?
Individual investors do not need to worry about bear traps unless they are investing on margin and betting against the market or individual stocks. If you’re betting against stocks, watch out for bear traps.
What Are The Adverse Effects Of A Bear Trap?
Besides loss, bear traps can have other negative consequences. The first to mention is a trader with bullish and bearish traders.
A bullish trader seeks to sell a declining asset to preserve profits, while a bearish trader seeks to sell an asset in order to buy it again when the price falls. But if the downtrend never occurs or reverses after a short period, the price reversal can be defined as a trap.
How Can You Avoid A Bear Trap?
You obviously need to avoid the bear trap to preserve your capital. Due to the frequent appearance of bullish and bearish traps on the charts, traders lose money, and the desire to return it can sometimes end in a complete loss of the deposit.
It should be emphasized that a bear trap in the market means a change in the price movement, so no one is safe from falling into it. Below we will look at methods that will allow you to be safe and earn at the same time.
