Bear Trap

A bear trap is a situation when the price of a certain security or any other financial instrument reverses briefly from a downward to an upward trend, creating a false indication of a changing trend. The term might also refer to a pattern on a graph describing such a situation, and is often used by technical analysts. Bear traps are widely common and might be spotted in all markets, including derivatives markets.

A bear trap might be a serious hazard to neophytes in trading and investing, as it’s generally considered that bear traps are often attempts of trading firms to lure individual investors into acting specifically with certain securities those firms are interested in. As far as trading firms possess a certain influence on the market, they might succeed in changing trends slightly. Those small changes are sometimes enough of a signal for an inexperienced trader to act, and then face a loss, or create a market situation which is more convenient for institutional traders controlling such an act.

Despite the circumstances described above, other reasons for bear traps to occur are also possible, including some external events not being controlled or planned by anyone.

Bear Trap principles

Suitable conditions for bear traps to occur often exist within markets with a huge demand to purchase securities, but with existing bids (prices offered to be paid for the securities) being unacceptable for most sellers. In such situations, potential purchasers can raise their bids, which in turn might allure more potential sellers, thus warming the market up, but after too much of the security is purchased, an abrupt fall of prices follows due to the changed balance between buying and selling pressure. On the graph, that usually looks like a downward trend, which might attract traders to take short positions or sell the stock. 

To get back to a higher demand, some market participants might manipulate the prices by setting them lower, thus making traders to believe there’s a bear market and the downward trend will continue. As this is a manipulation, after many investors buy the stock in question, the prices rise again, and traders with short positions have to close them, incurring significant losses.

A situation like that, with a seeming downtrend not coming true, is considered a bear trap, as it usually makes bullish traders to simply sell away an asset in question, while bearish traders often go for short positions. Taking a short position implies selling a security an investor doesn’t actually possess, but borrows from a broker. By selling such a security in a bear market, the investor hopes to repurchase it at a lower price later, gaining the difference as a profit. 

This is a highly risky practice because of a possibility of getting into a bear trap. With a lack of controlling and analyzing the market, an inexperienced or careless investor might mistakenly consider a temporary price decline to be a sign of a long downward trend, and suffer a greater loss as a result. A loss happens because of the necessity to close short positions after the security in question experiences a significant price increase, or otherwise an investor with the said short positions has to pay a comparable sum of money to his or her broker to cover the price differences. In any case, it implies expenditures, which grow as the price continues to rise.

Avoiding Bear Traps

As a bear trap might tempt a trader to participate in a potentially loss-making activity, it’s highly important to understand what a bear trap is and how to avoid it. Various technical analysis tools are used to notice and indicate typical features of a bear trap. Such tools are available on most charting platforms, and after some research, a trader might learn how to implement them for tracking bear traps.

The most popular tools for finding out a bear trap include the following:

• RSI (Relative Strength Index), which is used for detecting divergence, which is usually one of the key indicators of a bear trap;
• Fibonacci levels, which indicate a bear trap if no Fibonacci level is broken during a change of a trend;
• volume indicators, which low levels signal a possibility of bear trap.

As with many other market situations, no single tool or indicator should be used independently to indicate an occurrence of a bear trap. It’s important to remember that the information received through the use of a tool is required to be assessed with other indicators considered as well, as it creates a more detailed and truthful picture.