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Bear Trap Definition

Aug 20, 2022 4 min read

What Is a Bear Trap?

Any misunderstood pattern can cause significant losses to investors. While some patterns are pretty straightforward and easy to interpret, others can be tricky. A bear trap pattern is among the trickiest ones. That’s why it is important to know how to identify it and how to benefit from it.

A bear trap is a sudden price movement downwards. But this movement is temporary. After a while, the asset price recovers, and investors who were trapped lose their funds.

How a Bear Trap Works

When there are a lot of investors looking to buy a specific asset, and there are not so many sellers. the asset price may go up. This increase will, more likely, attract more sellers to the market which will disbalance the buying and selling pressure and send the asset price even higher.

But when buyers have purchased the asset, the selling pressure on the stock increases because investors earn only when they sell. That’s why when there are many people who are buying an asset, the selling pressure might potentially increase in the future because eventually, those people will be willing to sell the asset.

To make the demand grow, institutions may sell assets to push the asset price down and create an impression of a bearish market. When the price goes down, many beginners short sell the asset in the hope to earn on the price drop. Once the sales are made and the price dropped, the institutions start buying the asset back at a depressed price by pushing its value up.

Let’s elaborate on short selling an asset to make you understand better how it works and how one can earn when the asset price is dropping.

A short position is when a trader borrows assets from a broker through a margin account. Then, the trader sells the borrowed asset with the intent to buy it back when its price drops further. If the price drops indeed, the investor buys the asset for the funds received from its sale previously, repays the loan, and stays with some profit.

But if the asset price recovers, the investor has to face margin calls and loses funds.

That’s why understanding what is a bear trap in trading is important.

How To Avoid a Bear Trap

A bear trap is preceded by short-selling of the asset by a bunch of investors who hold a lot of the asset and ends when they have sold their coins and start buying them back at a low price.

A bear trap involves the price going in the opposite direction to a bullish trend. After a while, it swiftly reverts to resume its upwards movement. While short selling during a bear trap is a viable strategy, all short positions shall be perfectly timed. It makes this trading type extremely complicated.

It is difficult to identify a bear trap. To do so, traders need to use multiple trading indicators and technical analysis tools. Jointly, they can confirm whether the price is likely to reverse or you are dealing with an ongoing trend.

Any downward trend accompanied by low trading volumes may be a bear trap. Every trend change normally causes an increase in the trading volume. If the price changes its direction and the trading volume is low, it is a signal that you may be dealing with a bear trap. If you know how to read Fibonacci charts, you can confirm your guesses. For example, if during a drop, the price doesn’t break the key Fibonacci levels, the price reversal is to be expected.

Overall, it is better to avoid short positions in highly volatile markets.

Causes of a Bear Trap

In most cases, a bear trap appears when big investors are pushing the price down artificially by selling significant volumes of coins. When the coin price drops, the same investors start buying the asset back at a lower price. Then, the coin price recovers, and investors benefit from the price fluctuations.

Bear Trap Stock Chart Example

Here, you can see how a bear trap looks.

Source: https://www.tradingsim.com/day-trading/bear-trap-stocks
After a sudden and abrupt decrease, the asset price recovers to its normal level. The trading volume remains relatively low. When the price recovers, and the trend continues, trading volumes grow.

Or have a look at this chart.

Source: https://www.tradingsim.com/day-trading/bear-trap-stocks

Do you see the orange lines? Those are wedges, and they signal that a bullish trend is coming. It means that the price drop is a bear trap.

Special Considerations

Identifying a bear trap is not as difficult if you know how to read charts but trading during a bear trap is complicated even for experienced traders. That’s why it is better to avoid short positions and be careful in general.

FAQ

How long does a bear trap generally last?

Normally, a bear trap lasts for a short period of time, a couple of hours or days. In rare cases, it extends to some weeks or even months.

How to Identify a bear trap?

A bear trap can be identified by low trading volumes and by using other indicators and charts.


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