A bear trap is a technical pattern that occurs when the price action of a stock, index, or another financial instrument incorrectly signals a reversal from an uptrend to a downtrend. In other words, prices may move higher in a broad-based incline, only to encounter significant fundamental resistance or change. This prompts bears to open short positions, hoping to profit from an indication of falling prices.
A bear is an investor or trader in the financial markets who believes that the price of a security is about to decline. Bears may also believe that a financial market's overall direction may decline. A bearish investment strategy attempts to profit from the decline in the price of an asset, and a short position is often executed to implement this strategy.
A short position is a trading technique that borrows shares or contracts of an asset from a broker through a margin account. The investor sells those borrowed instruments to repurchase them when the price drops, hoping to profit from the decline. When a bearish investor incorrectly identifies the timing of the decrease in price, the risk of getting caught in a bear trap increases.
KEY TAKEAWAYS
1. Bear Trap Basics: A bear trap is a false technical indication of a reversal from an uptrending market to a downtrending one that can lure unsuspecting sellers.
2. Asset Markets: Bear traps can occur in all asset markets, including equities, futures, bonds, and currencies.
3. Temporary Corrections: Bear traps can take the form of a downside market correction amid an overall bullish move higher.
4. Caution is Key: It is difficult, if not impossible, to tell if the downward correction will continue or turn into a bear trap. So from a trading perspective, traders need to be cautious about their position size in case the overall uptrend reasserts itself.
Bear Trap vs. Bull Trap
There are two types of traps to look out for, bear traps and bull traps. Which one is occurring depends on the overall market conditions and trends.
Bear Trap
A bear trap occurs when there is a bearish correction or reversal amid an overall uptrend. A downward correction sees shorting temporarily overcoming buying pressure, leading to a short-term price fall. The decline may be small or large, potentially failing at recent price highs in the uptrend.
The downward correction may last several trading sessions, giving a false impression that the market has indeed reversed. Traders might take short positions to profit on falling stock prices, but when buyers begin seeing prices drop and increase their buying activity, the market won't support prices falling further. It then rapidly resumes its uptrend.
The traders with short positions face losses because they sold a stock at a specific price to repurchase it at a lower price later, but then the price rose and kept climbing. These short traders are then trapped in a losing position—they have to buy back the stock for a higher price, losing more capital the longer they wait to repurchase it.
Bull Trap
A bull trap is when an overall downward trend and a short-term bullish—or upward—trend in price occurs. Like a bear trap, this short-lived uptrend can trick traders into positions that can cause losses. In a bull trap, traders might take long positions because the market is falsely indicating that a reversal is underway. When the market resumes its downward trend, traders are left holding stocks that are losing value.
Causes of a Bear Trap
Bear traps generally occur when investors and traders notice that a price trend appears to have reversed over a period. There are many reasons a stock price might drop—government report releases, geopolitical events, company press releases, rumors of a recession, or anything else that might create doubt and fear of loss. As a result, investors begin selling, causing prices to drop.
The false trend can last for several trading periods; if traders suspect a reversal, they take short positions. As more traders start to sell and short, the price continues to drop until it hits a support level that causes it to rebound. The support level is determined by the market. It is generally represented by the price where buyers start flocking to the asset, increasing demand—which tends to raise the stock price rapidly and cause a trap for the bear traders.
Identifying a Bear Trap
Short sellers are compelled to cover positions as prices rise to minimize losses. After short-sellers purchase the instruments required to cover their short positions and buyers start buying, the downward momentum of the asset tends to decrease. A subsequent increase in buying activity can initiate further upside, which can continue to fuel price momentum.
The fundamentals are critical in identifying a bear trap, even for technical traders. Because a bear trap is a false indication, the only thing changing is the stock price. For instance, if none of the important fundamentals (e.g., economic and company financial data) have changed against your position, you shouldn't expect more than a limited Bear Trap correction.
If the fundamentals have changed, there's no reason the downward trend you're shorting shouldn't continue. If the overall trend is lower and a Bear Trap correction occurs, you have an opportunity to get short at better levels, looking for the up move to eventually resume—you'll still need to put a stop order above if you're wrong. On the other hand, if the trend is your friend, the appearance of a bear trap may signal an opportunity to get short on a corrective bounce with a view that the major uptrend is set to resume.
How to Avoid a Bear Trap
Some ways you can tell if a decline is a bear trap:
1. Observe Trading Volume: Look at the instrument's trading volume. If it is low, it may provide clues that it is a temporary price change.
2. Use Your Trading Tools: Put options and stop orders can help you minimize losses if the short down-trend is temporary.
3. Technical Analysis: Fibonacci retracements, relative strength index, and volume indicators can help you understand and predict whether the current price trend of a security is legitimate and sustainable.
4. Candlestick Indicators: Candlestick patterns such as Evening Star, Bearish Engulfing, and Three Black Crows can help you identify a bear trap.
In summary, a bear trap is a deceptive pattern in financial markets that can lead to significant losses for unsuspecting traders. To avoid falling into this trap, it's crucial to combine technical and fundamental analysis, closely monitor trading volume, and use risk management tools like stop orders and options. By staying informed and cautious, traders can reduce the risk of being caught in a bear trap and make more informed investment decisions.
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