A bear trap is a colloquial term for a specific stock market trading pattern. Essentially, it is a relatively quick fluctuation in a company or in the market as a whole that attracts speculators looking to gamble on future losses. In a true bear trap, however, the market quickly reverses back the opposite direction, “catching” these pessimistic investors.
What is a Bear Trap?
A bear trap, also known as a bear trap pattern, is a quick downward price movement that entices bearish investors to sell an investment short, followed by an upward price reversal. Short sellers lose money when prices rise, causing a margin call or compelling them to cover their position by buying back borrowed shares. A bear trap happens when a bearish correction or reversal occurs inside an overall rise. Shorting briefly overcomes buying demand during a downward correction, resulting in a short-term price drop. The drop could be little or significant, and it could fail at recent price highs in the upswing. The downtrend may extend several trading sessions, creating the impression that the market has truly reversed. Traders may take short positions to profit from declining stock prices, but when purchasers begin to observe prices fall and increase their buying activity, the market will not tolerate further price declines. It then quickly resumes its upward path.
Technical Trading Pattern of a Bear Trap
Market professionals identify bear traps by using past price movements of companies and markets to assist their trading. Although technical patterns and phrases might be confusing for new investors, it is beneficial to have a basic understanding of them. A “support level” in a stock or index is a price at which investors previously purchased stocks. In general, stocks tend to bounce higher off these levels as investors are tempted back into the market, providing support for shares.
When markets fall through so-called “support” levels, analysts predict greater selling. While this is generally the case, a break down through support levels can also revert quickly. This is a bear trap’s technical definition. Investors expect the break lower to be the start of more selling, but they are caught off guard when prices keep rising rather than falling.
Identifying a Bear Trap
Even technical traders ought to consider the fundamentals when recognizing a bear trap. Because a bear trap is a deceptive indicator, the stock price is the only thing that changes. For example, if none of the major fundamentals (e.g. economic and corporate financial statistics) have changed in your favor, you should only expect a limited Bear Trap correction.
If the fundamentals have changed, there’s no reason to expect the downward trend you’re shorting to continue. If the overall trend is lower and a Bear Trap correction occurs, you have an opportunity to get short at better levels and wait for the up move to resume—you’ll still need a stop order above if you’re wrong. If the trend is your friend, the development of a bear trap may signify an opportunity to short a corrective bounce with the expectation that the major uptrend will resume.
The bear trap chart pattern is a pretty straightforward setup. A recent range must be broken to the downside, preferably with strong volume. The stock must return above support within 5 candlestick bars before exploding out of the top of the range. The stock should have a reasonable price range, which is the final component of the setup.
How to Avoid a Bear Trap
Here are some clues that may let you know if a decline is a bear trap:
- Examining trading volume: You could examine the trading volume of the instrument. If it is low, it may indicate that the price shift is only transitory.
- Making use of your trading tools: If the short downtrend is just fleeting, stop orders can assist you limit your losses.
- Technical indicators such as Fibonacci retracements, the relative strength index, and volume indicators may help you understand and predict if a security’s current price trend is legitimate and sustainable.
- Candlestick patterns such as the Evening Star, Bearish Engulfing, and Three Black Crows might help you recognize a bear trap.
Volume Indicator
One of the most essential factors in finding bear traps is market volume. When a stock begins to reverse, approaching new highs or lows, you will notice volume increasing. But what if the market reverses course and volume is low? Take care! It’s possible that this is a bear trap!
Conclusion
Bear traps are a stock market “head fake,” enticing in negative investors only to whipsaw them as prices resume their upward march. The good news is that bear traps are a non-event for the average investor, and may even present an investing opportunity. However, if you are a negative investor by temperament, a bear trap is a risky trading pattern that could be costly. It’s vital to understand how bear traps work before diving into the world of selling stocks short and hoping to profit from price decreases.
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