A bear trap is a trading pattern characterized by dramatic declines in stock prices or market prices followed quickly by reversals. Bearish investors may be tempted to capitalize on the falling prices by short-selling creating the illusion of a Bear Market.
Still, when the prices reverse and climb again, they are left with a potentially costly position. This scenario is often referred to as a ‘bear trap’. That is because the bears are caught unaware and stuck in their losing positions.
Bear markets occur unexpectedly too. However, they shouldn’t be mixed with a bear trap, as a bear trap is short-lived whereas bear markets tend to last for months. Keep in mind that bull markets have their ‘bull traps’ too.
What is a Bear Trap?
A bear trap is a strategy employed by a group of traders who collectively hold a significant amount of a certain coin. They coordinate to sell a large quantity of that coins at the same time with the aim of creating the impression that there is a price correction happening in the market.
This prompts other traders to sell their own holdings, leading to further downward pressure on the price. Afterwards, the traders who set the trap will “release” it by buying back their assets at a lower price. This causes the value of the coin to rebound and the trap setters to profit.
The bear trap can happen over several days or within hours. It is triggered by high demand for stocks that outstrips the number of holders willing to sell. As buyers bid higher, it attracts more sellers and pushes the market upward.
Similarly, as in the stock market, the bear trap can be triggered by institutional investors. That happens when they sell large amounts of stock and push the prices down, in hopes that other market participants will follow and sell their stocks too. Once the price is fallen to their desired level, investors begin to buy them back in large quantities at the stock’s price. This way pushing price drops back up and making a profit.
Causes of a Bear Trap
When it comes to a Bear Trap, anything can be the trigger. Government releases, geopolitical happenings, corporate announcements – these seemingly innocuous events could quickly transform an economy into chaos.
As investors react to this information by selling their positions, the price of the asset begins to drop, fueling further selling and short-selling activity among traders. This can create a self-reinforcing downward spiral as more traders enter short positions, expecting the price to continue to drop.
However, a bear trap in stock markets can also be an opportunity for many investors. Especially for experienced ones who are able to identify the support level, which is the point at which demand for the asset begins to increase again, and buyers start to step in.
The support level is determined by market dynamics and is generally represented by the price at which buying pressure outweighs selling pressure. Once the investment prices reach this level, they can rebound and recover their value. This in turn can lead to significant losses for traders who entered short positions expecting the trend to continue.
Identifying a Bear Trap
Bear traps are important to recognize and understand. They can help traders determine when the overall trend is failing and potentially create an opportunity.
By being wary of bear traps, experienced investors can more easily detect when the market is taking a turn. This shift may be caused by institutional traders getting out at once, resulting in their peers potentially suffering losses. If these savvy players were to take advantage and swiftly buy back up again, this could result in them gaining from reduced prices.
However, staying ahead of market fluctuations requires a keen eye for the fundamentals. These include current market conditions, company performance, technical indicators and investor sentiment.
By considering these elements, traders can make knowledgeable decisions while staying within their risk preferences.
How to avoid a Bear Trap?
Some of the ways you can tell if a decline in the stock is a bear trap are:
Avoid Short Positions
Short selling can be a high-risk investment strategy, as the value of the stock could increase without limit and cause an infinite loss for the investor. Therefore, it is important to consider alternative methods to profit from market downturns that are less risky than shorting stocks.
Instead of short selling, investors can consider using put options as a less risky alternative to profit from market downturns. Put options are contracts that give the holder the right to sell or short a stock at a predetermined price.
The most an investor can lose with a put option is the amount they paid for the option.
Use the Relative Strength Index for Data-Driven Decision Making
When it comes to shorting a stock, relying solely on intuition can be a risky proposition.
To ensure more accurate predictions, investors should use data-driven decision-making with tools such as the relative strength index (RSI).
By understanding patterns, it can be easier to predict if a change in value represents a trend or is an isolated incident.
Be Cautious During Periods of Low Trading Volume
Before engaging in trading activity, it is important to consider the trading volume associated with the stock. Shorting a stock during periods of low trading volume can be risky as this increases the chances of falling into a bear trap. Low levels of trading activity may create false impressions of trends that do not necessarily reflect the sentiment of investors.
Making predictions about trends in the market is more reliable when there is high trading volume. That is because these times provide a clearer indication of investor sentiment. When considering market movements, always remember that low trade volumes paint an incomplete picture and can be misleading due to the influence of select players in the market.
