What is a Bear Trap?

A bear trap is a technical pattern that occurs when the performance of a stock, index, or other financial instrument incorrectly signals a reversal of a rising price trend. The trap is thus a false reversal of a declining price trend. Bear traps can tempt investors into taking long positions based on anticipation of price movements which do not end up taking place.

Key Takeaways

  • A bear trap is a false technical indication of a reversal from a down- to an up-market that can lure unsuspecting investors.
  • These can occur in all types of asset markets, including equities, futures, bonds, and currencies.
  • A bear trap is often triggered by a decline that induces market participants to open short sales, which then lose value in a reversal when shorts are forced to cover.

How Does a Bear Trap Work?

A bear trap can prompt a market participant to expect a decline in the value of a financial instrument, prompting the execution of a short position on the asset. However, the value of the asset stays flat or rallies in this scenario and the participant is forced to incur a loss. A bullish trader may sell a declining asset in order to retain profits while a bearish trader may attempt to short that asset, with the intention of buying it back after the price has dropped to a certain level. If that downward trend never occurs or reverses after a brief period, the price reversal is identified as a bear trap.

Market participants often rely on technical patterns to analyze market trends and to evaluate investment strategies. Technical traders attempt to identify bear traps and avoid them by using a variety of analytical tools that include Fibonacci retracements, relative strength oscillators and volume indicators. These tools can help traders understand and predict whether the current price trend of a security is legitimate and sustainable.

Bear Traps & Short Selling

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 the overall direction of a financial market may be in decline. A bearish investment strategy attempts to profit from the decline in 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, with the intention of buying them back when the price drops, booking a profit from the decline. When a bearish investor incorrectly identifies the decline in price, the risk of getting caught in a bear trap increases.

Short sellers are compelled to cover positions as prices rise in order to minimize losses. A subsequent increase in buying activity can initiate further upside, which can continue to fuel price momentum. After short sellers purchase the instruments required to cover their short positions, the upward momentum of the asset tends to decrease.

A short seller risks maximizing the loss or triggering a margin call when the value of a security, index or other financial instrument continues to rise. An investor can minimize damage from bull traps by placing stop losses when executing market orders.