What is a Bear Trap
A Bear Trap is a technical pattern that occurs when the performance of a stock or an index incorrectly signals a reversal of a rising price trend.
BREAKING DOWN Bear Trap
A Bear Trap can prompt a trader to expect a decline in the value of a stock or index, prompting them to take a short position on the asset. When this phenomenon occurs, however, the value of the asset stays flat or begins to recover. The trader shorting the asset would then be said to be caught in a bear trap.
The reverse of this circumstance, in which the reversal of a declining trend is falsely signaled, is known as a bull trap.
Investors often rely on technical patterns to analyze market trends and inform investment strategies. While a bullish trader may sell a declining asset immediately in order to retain whatever profits they have made, a bearish trader may attempt to short that asset with the intention of buying it back once 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. Most traders who get caught in bear traps tend to do so early in the trading session, and analysis of opening bell trends can indicate how frequently a particular asset falls in value, and at what time of day.
Technical traders attempt to identify bear traps and avoid them using a variety of analytical tools, including Fibonacci retracements, oscillators, and price and volume indicators. These tools can help traders understand and predict whether the current price trend of a security is legitimate.
Short Selling and Bear Traps
A bear is an investor or trader in the capital markets who believes that the price of a security is about to decline. Bears may also believe that the overall direction of a capital market may be in decline. A bearish investment strategy will be to attempt to profit from the decline in price of an asset, and one way that investor may implement is by taking short position on that asset.
A short position is a trading technique that borrows shares of an asset from a broker via a margin account. The investor then sells those borrowed shares with the intention of buying them back when the price drops. The intent in this strategy is to profit from the decline in price. When a bearish investor incorrectly identifies the decline in price, they run the risk of being caught in a bear trap.
Short sellers with bearish tendencies are compelled to cover their positions as prices rise in order to minimize losses. A subsequent increase in buying activity can initiate a rally, which can continue to fuel the upward momentum in price for the asset. After the bearish short sellers purchase the shares required to cover their short positions, the upward momentum of the asset tends to decrease, and can begin a period of decline in price, putting the short seller in precarious position.
Short sellers risk maximizing their losses or triggering a margin call when the value of a security or index continues to rise. Investors caught in this position are advised to consider a stop-loss order when executing trades as a preventative measure against the heavy losses that can result from a bear trap.