Table of Сontents
- What Is a Bear Trap and How Does It Work?
- Causes of a Bear Trap
- Bear Trap Stock Chart Example
- Ways to Avoid a Bear Trap
- Bottom Line
Investors that have a negative outlook run the risk of losing money if they fall into a bear trap. Find out how these technical patterns emerge and how investors can avoid falling for the trap that they set for them by learning how to protect themselves.
What Is a Bear Trap and How Does It Work?
Bear traps, also known as bear trap patterns, are abrupt price movements in the downward direction that tempt bearish investors to sell an investment short and are then followed by price movements in the upward direction. Short sellers incur losses if prices go upward, which may either result in a “margin call” or force the seller to “cover” their position by purchasing back the shares they had borrowed.
Note: Because a bear trap is a short-term pattern associated with technical trading, buy-and-hold investors should not use this approach because it is not appropriate for their investment horizon.
Bear Trap vs. Bull Trap
A misleading signal that indicates a break in a trend is at the heart of both a bull trap and a bear trap. This is followed by a reversal that heads in the opposite direction of the trend that was first seen. In either scenario, the investor or trader will experience a loss in the near term. The direction of the trends and reversals in bear traps and bull traps is in the opposite direction, which is the primary distinction between the two types of traps.
- Bear Trap: After an upward trend in price, a sudden breakdown in price below a key support level sends a false bearish signal, which entices bearish traders to sell short, only to be followed by a reversal upward in price. This causes bearish traders to sell short, which in turn is followed by an upward trend in price.
- Bull Trap: After the price has been moving in a negative trend, a sudden break upward in price over a major resistance level will give a false positive signal. This will entice bullish traders to open long positions, which will then be followed by a reversal in the price moving in the other direction.
Bear Trap vs. Short Sale
The practice of selling a stock or other financial asset short is referred to as a bear trap. On the other hand, a short sale and a bear trap are not the same things at all. If the price keeps going down, a pessimistic investor will be forced to undertake a short sale, which might provide profits for the investor if the price continues to go down. The rapid reversal back up in price, on the other hand, leads the short seller to incur a financial loss.
Note that short selling, also known as “selling short,” refers to the practice in which an investor, also known as a “short seller,” borrows shares or units of investment security, typically from a broker, and then sells the borrowed security with the expectation that the price of the underlying share will decrease. If the price of the share does decline, the investor may earn a profit by purchasing the exact same shares or units at a lower price and then selling them again. If the price of the security goes up after the short sale, the short seller could be required to cover the transaction by buying the shares back at a higher price, which would result in a loss of money for the short seller.
Causes of a Bear Trap
It is not only a decline in price that creates a bear trap; rather, it is a price that has fallen below an important support level. The bearish investor or trader anticipates additional negative movement in the event that a break through a resistance level occurs in the direction of the break. As a result, they are “stuck” and end up losing money once the downward trend in price reverses to an upward trend.
The causes of a bear trap are:
- a price decline that takes it below an important support level
- An investor or trader takes a short stake in security.
- The price quickly reverses direction and begins to go upward after a short drop below the support level.
Bear Trap Stock Chart Example
Consider the following situation as an illustration of a bear trap chart: traders were keeping an eye on a critical support level of $425 on the SPDR S&P 500 ETF (SPY), which is a proxy for the US stock market. Some investors engaged in stock shorting on the assumption that a sustained move below this support would be seen as a negative signal. Nevertheless, the price turned around, which resulted in financial losses for short sellers.
Ways to Avoid a Bear Trap
The only certain approach for a trader to avoid being caught in a bear trap is to steer clear of taking any short positions at all costs. However, there are other methods available than short selling, such as put options, and there are also techniques to steer clear of specific circumstances, such as low trading volume, which increases the risk of bear traps occurring.
Ways to avoid a bear trap are:
- Avoid short positions when there is not much activity in the market for investment security. When traffic is low, the potential for bear trap danger might grow.
- Using alternative trading strategies and purchasing put options is one strategy that might help reduce losses. In principle, there is no limit on the amount of money that may be lost by short selling.
- Advanced traders may use Fibonacci levels, It makes use of a type of technical analysis that may assist a trader in determining levels of support and resistance in a market.
- Avoid entering into a short position altogether.
A drop in the price of an investment asset may be the source of a bear trap. This prompts pessimistic investors to start short sells, which subsequently lose value when the price movement reverses course and begins to climb again. Because it includes technical trading, a bear trap pattern is not an investment strategy that is appropriate for long-term investors.
What is a bull trap?
- A bull trap occurs when a downward trend in a stock or other investment security breaks upward and above a key resistance level. When the price of the investment is able to sustain a break above the support level, bullish investors are more likely to purchase shares. The price moves in the other direction, which results in a loss of value for the bullish investor.
How do you identify a bear trap?
- The price of an investment asset is said to have entered a bear trap when it dropped below a crucial support level and saw an increase in the number of short positions taken by pessimistic investors. The negative trend eventually reverses back into an upward trend, “trapping” the bear who was trading without any prior knowledge into a losing position.
How long do bear traps generally last?
- The early price movement that leads to a bear trap might take weeks or months to create, but the bear trap itself, which is the moment at which the price breaks through a support level and reverses course back upward, can happen almost instantaneously.