What Is a Bear Trap?
Investing is a tricky endeavor, and there are many tricks and traps that the uninitiated can fall into. The bear trap is one of them. 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 to take long positions based on the anticipation of price movements that do not occur.
- 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 participants must cover the shorts.
How a Bear Trap Works
In some markets, there may be plenty of investors looking to buy stocks but few sellers who are willing to accept their bids. In this case, the buyers might increase their bid—the price they are willing to pay for stock. This will likely attract more sellers to the market, and the market moves higher because of the imbalance between buying and selling pressure.
However, when stocks are acquired, they automatically become selling pressure on that stock because investors only earn profits when they sell. Therefore, if too many people buy the stock, it will diminish the buying pressure and increase the potential selling pressure.
To increase demand and get stock prices to rise, institutions might push prices lower so that the markets look bearish. This causes novice investors to sell stock. Once the stock drops, investors jump back into the market, and the stock prices rise with the increase in demand.
How Bear Trap's Affect the Investor
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 and 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 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 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 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 traps by placing stop losses when executing market orders.