What Is Bear Trap In Stocks?
A bear trap is a technical stock trading pattern reflecting a misleading reversal of an upward trend in the financial market. Amateur traders fall into the trap of believing this suspicious temporary breakout to continue as a long-term downward trend and begin selling their short positions, only to incur a loss.
It happens when an upward stock marketStock MarketStock Market works on the basic principle of matching supply and demand through an auction process where investors are willing to pay a certain amount for an asset, and they are willing to sell off something they have at a specific price. trend suddenly stops and a short-term downward price movement starts. This bearish momentum quickly transforms into a market reversal, followed by a sharp rally, and creates a trap for traders. Institutions set the trap by pushing the stock prices lower to create more demand and drive stock prices higher. Aside from stocks, the pattern is common in trading equitiesTrading EquitiesEquity trading refers to the corporate action in which a company raises more debt to boost the return on investment for equity shareholders. This financial leverage process is considered a success if the company can earn a more significant ROI., bondsBondsA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually., currencies, cryptocurrencies, CFDs, and futures.
- A bear trap is a temporary but sudden downtrend occurring after a long-term uptrend and quickly followed by a sharp rally of the stock.
- Novice traders start selling their stocks at a much lower rate, fearing the decline to continue for long. But as the market reverses up, they end up incurring huge losses.
- For a trap like this to exist, the price decline should necessarily be either 20% or more from an all-time high over two months.
- Analyzing the market trend using technical tools, making smart bearish investments, and building a solid equity base would effectively help investors avoid a trap.
How Does Bear Trap Trading Work?
According to the Securities and Exchange Commission, traders can recognize a bear market based on the decline in prices of stocks or indices. If the fall is around 20% or more from an all-time high over two months, the market is considered bearish. This bearish situation is susceptible enough to create a trap for novice traders.
Seasoned traders keep a tab on market indices and purchase stocks when prices fall. It is the time when most investors want to buy assets at lower prices but hardly find any sellers. To lure more and more sellers, interested buyers raise their bids for those stocks.
The rising demand for a bear trap stock increases the selling pressure, affecting the buying chart. This imbalance caused due to increased demand and lowered supply shows a negative market trend. It puts a halt to the upward trend in the chart.
For experienced traders, this is the perfect time to make novice stock owners sell their assets at a lower price. As the reversal of upward trend gives a false impression of deteriorating market condition, the latter agrees to do this.
This tricky scenario created intentionally by a group of mature investors or institutions is called a bear trap. It tricks traders to sell short to minimize losses and lures them to take long positions anticipating the downward trend to continue, though it never happens.
Low-volume trading is a clear indicator of such a trap. In bear trap trading, mature investors buy assets from their novice counterparts and sell them as soon as the market status reverses and turns bullish. Trapping the amateurs, therefore, becomes a profitable opportunity for them.
- On August 6, 2019, the Texas-based activist short-selling operator Bonitas Research made a misleading tweet that the agricultural investment firm Rural Funds Group is a fraud. It led to a decline of up to 42% in the prices of Rural Funds’ stocks, leaving its long-term shareholders panicked. Fearing this tricky downtrend to be a genuine one, they started selling a short portionSelling A Short PortionShort Selling is a trading strategy designed to make quick gains by speculating on the falling prices of financial security. It is done by borrowing the security from a broker and selling it in the market and thereafter repurchasing the security once the prices have fallen. of their holdings. However, the company won its case against Bonitas Research in the Supreme Court of New South Wales. Its share prices recovered and touched new highs, while its shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares. suffered huge losses due to the trap.
- In April 2020, the COVID-19 crisis made many traders and experts believe that the financial market is entering a bearishBearishBearish market refers to an opinion where the stock market is likely to go down or correct shortly. It is predicted in consideration of events that are happening or are bound to happen which would drag down the prices of the stocks in the market. trend. Even though all leading indices were performing historically well, including S&P 500 (25%), Dow Jones (28%), NASDAQ (23%), they were of the view that spikes give a false impression of market recovery after their lows of March 2020 and will not last long. They further cautioned that it is a trap, and until the economy reopens, the entry of new investors in this phase will result in significant losses for them.
How To Avoid Bear Trap?
A bearish market is not always a bad market. There are multiple ways in which traders, especially the amateur ones, can avoid being trapped.
#1 – Do Not Short Sell
Short selling is considered a risky venture in trading and can lead to significant losses. Therefore, it should be strictly avoided during bear traps. However, if someone still wants to sell short, they must use a stop-loss order to limit the loss on a position.
#2 – Make Smart Investments
Amateur traders should invest in either small proportions or stocks of big companies with a history of successfully sustaining the challenging market conditions. Such financial instruments would survive the decline, even if the downtrend continues for long. Investing in such assets will keep traders from falling into a trap.
#3 – Take The Opportunity
In the bear market, the values of the assets decline, and this downtrend continue for a more extended period. It is the time when investors buy a large number of stocks at a much lower rate. In short, traders get an opportunity to build their holdings in the stock market by owning a maximum number of assets to trade later on.
#4 – Analyze The Trend
A bear trap is a trade pattern that depicts a sudden temporary downward trend. It scares novice traders of the suspected prolonged downtrend further. As a result, they start selling short positionsShort PositionsA short position is a practice where the investors sell stocks that they don't own at the time of selling; the investors do so by borrowing the shares from some other investors to promise that the former will return the stocks to the latter on a later date. anticipating a further decline in the asset values. But contrary to their anticipation, the market turns around.
To avoid such a situation, traders do technical analysis using different trading tools, such as market indicators, volume indicators, Fibonacci retracements, etc. Predicting the trap helps amateur traders remain out of such tricky situations.
Frequently Asked Questions (FAQs)
A bear trap occurs when the trade pattern falsely implies the beginning of a long-term downtrend after an uptrend. But the market reverses up after a brief period and creates a trap for short-sellers. It happens due to the imbalance between the selling pressure and the buying pressure, with the latter being more.
Institutions lower stock prices that give amateur traders a false idea of a suspected long-term downtrend. Out of the fear of incurring huge losses, novice traders start to sell short positions at a lower cost to seasoned traders, thereby getting trapped.
A bull trap is a technical trade pattern that reflects a sudden but temporary reversal of a decline in the stock value in the market. A bear trap is the false reversal of an uptrend, making novice traders short sell their positions at lower prices.
This has been a guide to What is a Bear Trap & its Definition. Here we discuss how does it work and examples along with how to avoid the bear trap? You may also have a look at the following articles to learn more –