RV Blog What is a Bear Trap?

What is a Bear Trap?

What is a Bear Trap?

A bear trap is common when trading various assets such as stocks, currencies, and commodities. It’s a technical pattern where the price dips or starts falling, then quickly reverses upwards. The asset’s price quickly recoups the losses suffered in the short-term dip, defying trader expectations. It’s a trap since it encourages trend-following traders to enter a short trade anticipating further declines. However, buyers step in, creating demand and increasing asset prices. The reversal might trend higher as short sellers rush to buy to cover their positions.

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What is a bear trap in stocks?

In stocks, bear traps occur for several reasons. Typically, a stock might dip temporarily, breaking support or moving below a key moving average due to fundamental or technical reasons. Fundamental causes such as poor earnings guidance or an executive departure may lead to a sudden dip in a stock. The stock might immediately rally back if the market has priced in the bad news. In the case of technical analysis, a stock may dip slightly below support but quickly reverse, indicating that buyers are willing to buy at the support price. Persistent buying at or slightly below support can bring in more buyers as the support level continually becomes the price that buyers are willing to step in. Consequently, traders who bet on a break below support or a bad news dip now face a reversal.

Related: Buying the Dip

Short sellers can be susceptible to bear traps since they profit by taking bearish positions to benefit from falling stock prices. They have margin accounts with their brokers to borrow stocks and sell them on the market. They aim to repurchase the stock at a lower price when prices decline, realizing a profit. However, if a stock’s downtrend reverses and starts to appreciate, they start to accumulate losses.

Sometimes sophisticated traders set bear traps by briefly pressuring a stock to dip below its support. Short sellers are encouraged to enter the trade if a stock breaks support or experiences downwards momentum. The breakdown attracts trend followers who view the break below support as a short opportunity. As short sellers pile in on the short trade, large, sophisticated traders then place large buy orders, triggering an immediate reversal. Increased demand and lower supply of shares trigger upwards price momentum.

Such a reversal immediately inflicts losses on short sellers who had just entered their trades. As the stock moves higher from its selling price, its losses widen, and they might have to cover to avoid margin calls. On the other hand, sophisticated traders looking to offload their positions as short-covering buying pushes the price higher and higher.

A stampede to cover in the face of rising prices can lead to a violent rally that creates a vicious cycle of short-covering buyers. Demand increases as short sellers buy to close their positions, making the stock move higher, triggering more stop losses and margin calls. Momentum traders can also jump in, fueling a parabolic rally. Short sellers have to chase the stock and cover at higher levels.

Characteristics of bear traps – How to identify them

There are various identifying characteristics of bear traps. A price decline or a break below support doesn’t necessarily mean a stock will continue falling. It may just be a shallow decline that pivots into a price rally. Typically, bear traps occur in strong bull markets, with low volumes observed as stock prices fall.

A bull market has support from strong economic activity, relatively low long-term interest rates, and low unemployment. The analogy that a rising tide will lift all boats applies in such a market. All sectors trend up in unison with the market, and prolonged weakness is a rarity. In bull markets, most stocks are in an uptrend, occasionally interrupted by quick and shallow corrections. Most stock price declines in bull markets are temporary and might represent a bear trap, especially if the economic fundamentals are strong and the upwards trend is intact.

Volume is another key indicator used by technical traders to identify bear traps. The volume traded on a stock can indicate the depth and velocity of a move. Prices falling on low volume might mean a bear trap. For downtrends to be sustainable and continue, there must be high volume selling. Therefore, a decline in low volume may indicate a lack of conviction in the downward move.

Finally, technical traders use sophisticated tools to establish retracement levels and degrees. Some of the most common tools are the Fibonacci retracement levels. If a stock fails to break a critical Fibonacci level, the upward trend is still in place.

What are the causes of a bear trap?

A bear trap can occur for a variety of reasons. It may be due to technical factors such as breaking support, sophisticated traders using algorithms to trigger short squeezes, or overcrowding on the short side. A news release relating to stock or economic news can also cause a bear trap.

Fundamental reasons

Stock prices are affected by specific business, economic, or geopolitical news. An announcement relating to a stock’s revenues, earnings, business outlook, or regulation can cause a downward movement in price. Also, macro factors such as economic growth, central bank policy, and political news can lead to a temporary dip. For example, the Federal Reserve may announce an interest rate hike, pushing growth stocks lower. However, if the market anticipated the bad news and priced it in, the stocks will erase losses and rebound to positive territory.

Price breaking support

Most stock traders use technical analysis to enter positions. Key support levels are areas of buying or selling. They watch stocks breaking support or moving averages to take short positions. However, sometimes this can be the consensus approach, and sophisticated traders who can move markets take the opposite position. Knowing more traders go short once support breaks, they take the opposite trade. Once the price starts rebounding, buyers step in, and now the stock rises above support.

Continued buying creates a quick reversal, pressuring shorts to cover once the stock moves back above support. As more short sellers cover their position, they push prices higher, pressuring other shorts to cover theirs, leaping more profits for the sophisticated traders on the long side.

Overcrowding on the short side

Short sellers initiate positions by borrowing stocks and selling into the market. At a certain point, the selling activity is exhausted. There are no additional sellers and no supply of shares to sell, leaving only buyers in the market.

Sophisticated traders

Sophisticated trading firms that use statistical and algorithmic trading can create traps to fool traders on the other side of the trade. They may initiate selling on a stock hoping to lure in short sellers and then switch their position to benefit from the subsequent short squeeze.

The Bottom Line

Bear traps are a source of pain for traders, as expected price falls don’t materialize. Instead, upward solid reversals happen, leading to short-selling losses. Bear traps are common in bull markets and happen with low volumes. Avoiding bear traps requires traders to follow technical analysis rules, waiting for a downtrend confirmation from a high-volume dip or a break below key Fibonacci levels.

RELATED CATEGORIES: Investing