What is a bear trap?
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.
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 from 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
Causes of a Bear Trap
Bear traps generally occur when investors and traders notice that a price trend has reversed over time. A stock price might drop for many reasons—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 drops until it hits a support level that causes it to rebound. The market determines the support level. 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 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 stock price is only changing. For instance, if no essential 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. Suppose the overall trend is lower, and a Bear Trap correction occurs. In that case, you can get short at better levels, looking for the upmove to resume eventually—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 are:
- 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.
- Use your trading tools: Putting options and stopping orders can help minimize losses if the short-term downtrend is temporary.
- Technical analysis: Fibonacci retracements, relative strength index, and volume indicators can help you understand and predict whether the current price trend of security is legitimate and sustainable.
- Candlestick indicators: Candlestick patterns such as Evening Star, Bearish Engulfing, and Three Black Crows can help you identify a bear trap.
Real-World Example
You can find examples of bear traps in many stocks during overall market uptrends. For instance, in the bear trap image above, ConocoPhillips’ stock price was trending up for several months before it began falling. It dropped rapidly in early October 2022, traded at support for a few days, rebounded to its previous price level, and continued rising.
Traders who took short positions for the 9-day period the stock was declining would have been caught in a bear trap if they hadn’t placed stop orders or taken other action to ensure they weren’t snared in the trap.
How Do You Trade a Bear Trap?
One method is to use a short and ensure you place a stop order in case I don’t think you’re right about the reversal. If the fundamentals still look good, you could consider entering a long position during the downtrend to profit on the upside.
Is a bear trap bullish?
A bear trap is short-term bearish but long-term bullish because it usually occurs in a bullish market trend.
What is a bull trap vs. a bear trap?
A bull trap is the opposite of a bear trap, where traders might assume a downward trend is reversing and begin to take long positions, only to watch the market resume its downward trend.
When it comes to trading, there is probably nothing more irritating than a bear trap. One day, you’re with the downtrend, and price action looks promising for further weakness. Then, the market abruptly changes course upward based on news, data, or simple market dynamics (too many shorts or not enough longs). Now, you’re forced to sit through what might be a minor bounce or a more significant correction.
It’s tough to identify a bear trap until you see your position moving against you after it forms. Hopefully, you have heeded the advice to always have a stop-loss order before getting into any position. If so, it prevents the panic you may feel when the trend reverses course against you.
Conclusion
- A bear trap is a false technical indication of a reversal from an up-trending market to a down-trending one that can lure unsuspecting sellers.
- Bear traps can occur in all asset markets, including equities, futures, bonds, and currencies.
- Bear traps can take the form of a downside market correction amid an overall bullish move higher.
- 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 if the overall uptrend reasserts itself.
