How To Avoid Falling Into The Bear Trap
Have you ever got bowled over by an unexpected trend reversal – the market signals a downtrend initially only to switch and rise again? This type of situation is called a bear trap.
Bear trap is a colloquial term used to indicate a possible onset of a downturn in the market. But like the name indicates, it is a trap. The market instead breaks into steady growth after a short pause. Beartrap can happen in any market, stocks, indices, or other financial instruments.
The impact of bear trap can vary, but one thing is fixed, traps are deceptive. Technical traders use different trading tools to identify a bear trap; we will discuss them in due course.
Why is it called a beartrap?
In the market, bull and bear are two terms used to describe two opposite market sentiments. When the market is rising with predominant buying forces, it is called a bullish trend. The opposite of it is a bearish condition, when the market is falling, mainly due to a selling spree.
Most traders will lean towards one or the other side of the spectrum, and hence, you have traders trading during both bullish and bearish market. A bearish trader will look for price patterns that are indicative of a downtrend so that they can short sell and exit trade to secure profit.
A bear trap is a condition that happens during an uptrend; it stops abruptly. A bearish trader may consider the situation a possible beginning of a downtrend and engage in short selling. It occurs when traders take on a short position when the stock is breaking down, hoping to buy back at a lower price, but the trend reverses and shoots up. It produces a trap followed by a sharp rally.
Identifying a bear trap in the chart is quite simple. It occurs close to the support line. There is a downtrend accompanied by a high volume trade. A trap is confirmed when the trend reserves within five candlesticks, forming above the support line and the trend rapidly crosses the resistance level. The second thing that you need to confirm is that the stock has a decent price range. Trading opportunities increase when the asset has a wide price range.
How does a bear trap work?
A bear trap prompts traders to think there is a downtrend, with a decline in the price of the financial instrument. But the value of the asset remains flat, or worst, rallies, in which case you would be forced to incur a loss. A bullish trader may take a short position in a declining asset price, while a bearish trader may short to buyback when the price drops to a certain level. But in a bear trap, the trend reversal happens in the opposite direction.
Trading in bear Trap
Traders popularly use a bear trap for shorting or short selling. Shorting is a process of selling high and buying the same asset when the price is falling to generate profit from the trade. In bear trap trading you can short in a couple of ways like borrowing the stocks from the broker on margin. You sell the shares at the current price when you expect the market to fall to buyback at a lower price to return to the broker. Exercising shorting in a bear trap increases your risk manifold. When the price rises, instead of falling, you end up paying more for the stocks while repurchasing to maintain your margin. So, when a bear trap occurs the risk assumed by a bear trader is multiple times more than bullish traders.
Traders use multiple technical trading tools like Fibonacci retracements, relative strength oscillator, volume indicators, and more to segregate a bear trap from a genuine trend reversal. If a strong bullish trend suddenly gets disrupted by a suspicious downtrend, instead of jumping to it, you must check other market parameters to understand why it happened. If there is no meaningful change in market sentiment to cause a reversal, then it probably is a bear trap.
Market volume is a critical indicator that can help you identify a bear trap in advance. Market volume changes significantly when a share price approaches new high or low, to indicate changing sentiment. But if there is a price drop without a significant rise in volume, then it probably is a trap.
Fibonacci bands are another crucial tool that can give early warning. If the share price doesn’t cross critical Fibonacci lines, then the trend reversal is probably a short-lived one. If you encounter a sudden downtrend and not sure what it means, look at the indicators. Indicators can give strong signals, and you can spot a divergence easily on a chart.
Often stocks break into a rally after a bear trap happens, influenced mainly by short-term traders who try to capitalise on the falling market. The second wave comes when the majority realise that the uptrend is sustainable and not a dead cat bounce. The second wave is often stronger than the first bounce and crosses the short-term top eventually.
Recapitulation
– A bear trap is a false trend reversal pattern, and it can happen in all types of market
– It deceives traders who open short sell position which then loses value
– A bear trap is a common occurrence in equities, bonds, futures, and currencies market
– Trading risks will increase more for short traders during a bear trap than bullish traders if they misinterpret the trend
– You can use technical charts to identify a bear trap in advance
– If the price action signals a possible end of a bear trend, then a divergence from it can indicate a trap
– You can minimise your losses by placing a stop-loss
– Bull traps also occur in the market, but its function is reverse
Conclusion
A bear trap is an occurrence you can’t avoid. If you are inexperienced, you might find it difficult to spot on a trading chart in advance. But with experience and the help of market indicators, you will learn how to identify a trap. If you encounter a sudden downtrend and don’t know how to react, always apply a stop-loss. It will mean that you can’t lose more than what you have planned.
