DEFINITION of 'Bear Trap'
A bear trap is a false signal that the rising trend of a stock or index has reversed when it has not. A bear trap prompts traders to place shorts on the stock or index, since they expect the underlying to decline in value. However, instead of declining further, the investment stays flat, or slightly recovers.
A bear trap is the opposite of a bull trap.
BREAKING DOWN 'Bear Trap'
In the capital markets, a bear is an investor or trader who believes that the price of a security (or securities) is poised to go down. A bear may also have sentiments that the overall direction of the capital market is headed downward. Bears, therefore, attempt to profit from a decline in the value of a particular security or the market in general. In order to do this, a bear could employ a short position on the security.
A short is a trading technique that involves borrowing shares from a broker through a margin account, selling the shares in the market, and buying back the shares when the price drops. A short is the opposite of a long position, which is the conventional investing practice in the financial markets. An investor who goes long on a security or market is typically a bull who believes that the security is going to increase in value, and therefore, hopes to take advantage of the future higher price by buying the security today. When the price goes up, the bull will sell for a profit. On the flip side, a bear would short a position to profit from any price fall.
A bull or bear may rely on technical patterns that indicate the bullish trend of a security has reached a peaked. Immediately the asset starts going down, a bull who was long the asset may sell it immediately to keep whatever profits have been made. A bearish trader may short the asset with the intention of buying it back when the price has dropped to a certain level. However, the pattern is tagged a trap if the downward movement never happens or happens for only a short while but reverses rather quickly to the bullish path it was on before its value dropped briefly. This price reversal is referred to as a bear trap, i.e. a trap for bears.
When a bear trap is evident, the investor who sold may regret selling early, given that the price of the security is actually still moving up. Short sellers with bearish sentiments are forced to cover their positions at current high prices to minimize their losses. The increase in buying activity for the asset creates a sharp rally, which further fuels the upward price momentum of the asset. After short sellers have purchased the shares needed to cover their losing short positions, the upward momentum of the security decreases, and the price of the asset may actually start going down.
Short sellers run the risk of maximizing their losses or triggering a margin call if the price of the security or value of the market index keeps going up. Investors should always consider a stop-loss order when executing trades in order to avoid the heavy losses that can come out of a bear traps.
Technical traders may be able to identify and avoid bear traps when the signals pop up on their charts. Using and understanding technical indicators like Fibonacci levels, Oscillators, and price and volume indicators could let a trader know whether the bearish trajectory of the market or security is legitimate or whether it’s a trap. Most investors who fall into a bear trap do so early in the trading session, and analyzing opening bell trends should indicate how often a particular investment falls in value early in the day, compared to later on.