A bear trap is a false technical indication of a market reversal from down to up that can entice incautious investors. This can happen in any asset market, including equities, futures, bonds, and cryptocurrencies.
A bear trap is frequently triggered by a decline that causes market participants to open short sales, which then lose value in a reversal when the shorts must be covered. In this article, we would be looking at how the Bear trap works, and how to avoid it but first, let’s have a deeper definition of what a Bear Trap is;
What Is Bear Trap?
According to a technical analyst, institutional traders try to set up bear traps in order to entice retail investors to take long positions.
If the institutional trader is successful, and the price briefly rises, it allows the institutional traders to unload larger positions of stock, which would otherwise drive prices much lower.
For both novice and experienced investors, a bear trap can result in significant financial loss. Investors may be tempted to sell short, risking losing money due to price volatility.
As they try to time the market, these investors will frequently make multiple cryptocurrency transactions in a short period of time.
Savvy investors, on the other hand, may be aware that the price drop will be temporary, and they may continue to hold the asset for long-term gain.
The investors who set off the bear trap, causing the price drop, may have to wait for a while for the price to bottom out before buying at a low price and positioning themselves for significant gains.
How Bear Trap Works
In some markets, there may be a large number of investors looking to buy stocks but a small number of sellers willing to accept their offers. In this case, the buyers may raise their bid—the amount of money they are willing to pay for the stock.
This is likely to attract more sellers to the market, and the market will rise as a result of the imbalance in buying and selling pressure.
When stocks are purchased, however, they automatically create selling pressure on that stock because investors only profit when they sell. As a result, if too many people buy the stock, the buying pressure will be reduced while the potential selling pressure will increase.
Institutions may lower prices in order to increase demand and cause stock prices to rise, making the markets appear bearish. This causes inexperienced investors to sell their stock. When the stock price falls, investors rush back into the market, and stock prices rise in tandem with the increase in demand.
Spotting A Bear Trap
A bear trap is usually caused by speculative investors who want to take advantage of other investors’ inexperience. Bear traps are typically associated with speculative assets, such as cryptocurrencies.
They are most common with assets whose prices are rising rapidly. If you look at the trade volume, you might be able to spot a bear trap in action.
A significant increase in activity that coincides with a sharp, sudden drop in price may be a bear trap. Investors should carefully consider these factors before selling or developing a plan for a long-term hold that protects them from a bear trap loss.
How To Avoid A Bear Trap
Every day, bears make bad trades, but not every trade is a bear trap. A bear trap is the result of several avoidable factors that can ruin your day on the short side but with these tricks, you would quickly spot a Bear Trap;
Practice Disciplined Risk Management
The most important factor in protecting your trading account from any trade is risk management. It’s difficult for any trade, bear trap or not, to cripple you if you plan and manage your position size, and stop loss and risk per trade.
As a short seller, you will encounter some difficulties. When we click the “sell short” button on our brokerage platforms, we all know this, so plan ahead. Aside from establishing a stop loss, we must also establish a reasonable risk per trade. Even the best traders only win 60% of the time, so expect to lose frequently.
As a result, you must take a reasonable risk per trade, expressed as a percentage of your account. According to Van Tharp, a top trading coach and author of several books on trader performance, position sizing and your average risk per trade are the second most important aspects of trader success after psychology.
He cites a 1991 Financial Analysts Journal study conducted by Brinson, Singer, and Beebower that examined the performance of 82 pension fund managers over a 10-year period. The study discovered that position sizing, rather than asset allocation, account for 91% of performance variability.
In other words, rather than which positions they held at any given time, the majority of their performance can be attributed to how they sized their positions. In his own testing with traders, he discovered that the “sweet spot” for risk on any trade is around 1.5% of your trading account. This number will, of course, vary depending on the size of your account and your level of aggression.
When most traders in bear traps reach their maximum loss on that position and do not have a stop loss, they freeze. They try to “win back” some of their losses tactically rather than cutting their losses and exiting. Because several other bears are also in the position, the stock usually continues to rise, exacerbating their losses.
The best strategy here is to exit as soon as you reach your maximum loss size because you can always re-enter later. Every minute you don’t cover your shorts, you’re actively shorting the stock.
Consider this: if you weren’t already in the position, would you set up a short position here? If not, exit the trade and wait for another opportunity. The most important thing is that if you don’t lose all of your chips, you can keep playing another day.
Don’t Ignore the Big Picture Technical Pattern
Trapped traders are there for a variety of reasons. They have not been disciplined by risk managers, they are succumbing to the loss aversion fallacy, and they are usually missing some key technical factors that indicate they may become trapped.
Consider the case of a parabolic low-float stock. NaturalShrimp is an OTC “aqua-tech” company that claims to have a novel method for producing high-quality shrimp.
The conventional wisdom on this stock is to short the first red day. According to the theory, these companies are pumped by insiders and email newsletters and will fold under any pressure. Insiders have already sold at this point, leaving only bagholders.
This is a very valid trading method in which many people make a living. As a result, when things don’t go as planned for short sellers, these can become the deadliest bear traps.
With the benefit of hindsight, we can see that $SHMP’s first red day on December 16 was a Doji candle—not exactly a decisive drop. We can deduce this from the intraday action on that day.
At the open, the price was rejected. A string of red candles is twice as wide as the average range. Most bears believe that this stock is about to crash. It’s difficult to blame someone for running out of gas early in the day.
However, the tone of the price action shifted. The stock recovered from its lows and finished near its opening price. This intraday movement should provide bears with new information.
Following a decline, there was enough intraday demand to prevent a waterfall. This is unusual for most stocks of this type, so it’s worth at least lowering your size to the close.
The next day, the same thing happens. We now have two data points. The stock found short-term support, delaying what many see as the inevitable fall of such a stock.
Again, we know that $SHMP continued to rally because we have the benefit of hindsight, as it has increased nearly 40% since the December 17 close.
After two days of cautious selling, it became clear that this stock is not operating strictly within the parameters of a low-float pump and dump.
If you’re familiar with how these stocks trade, you’ll notice that they usually crash, and most traders regret not arranging a location with their broker.
Don’t Short Into Upside Momentum
Markets experience periods of range expansion and contraction. Most stocks are still in a range contraction phase, meaning they aren’t doing much most of the time. Bear traps, on the other hand, occur at the far end of the range expansion spectrum and at the most unexpected times.
When a market’s range is expanding, one side of the trade is typically “in control.” Normally, this is fairly obvious.
For example, after a long period of range contraction, real estate asset manager St. Joe (JOE) recently entered a significant range expansion phase. The bulls clearly have the upper hand. Rallies are strong and unassailable, while pullbacks are shallow and timid.
One of the most common blunders made by short sellers is losing sight of where the significant energy is flowing. In a stock like $JOE, it’s clear that the bulls are in charge, and the energy is flowing in that direction.
Shorting a stock like this right now is a recipe for disaster. The most common way for traders to become trapped in these stocks is to try to short a new bout of momentum.
Take a look at the chart below:
These large moves have a tendency to be faded, especially on the first red day. This is almost always a bad idea.
These large momentum moves indicate that the stock is in high demand and that large buyers are making moves.
Because it can take several days to weeks for institutional buyers to establish their full-sized position, they are likely to take advantage of any dip-buying opportunities.
This is not to say that stocks that receive new institutional backing are invincible; they fall like rocks all the time. It’s just one more advantage in our favor.
Don’t Try to Be Early
“It’s not about getting the lowest price; it’s about getting the right price,” says Market Wizard Mark Minervini.
Waiting for confirmation to establish a trade makes it much easier to know if you’re wrong.
Consider the following Macy’s (M) stock example:
The stock has fallen from its highs, but it is still in an uptrend pattern. Rather than getting short ahead of time and potentially riding the stock back up to a new high, it’s much easier to know where your trade stands if you wait for it to break its uptrend pattern.
I’d rather short closer to $10 than “cheat” and short at $10.50 while the stock is technically still in an uptrend.
As a result, I could set a stop loss at around $11 and wait for the next swing low. Because if the market tests a new low and experiences price rejection, I know that the uptrend pattern will likely continue to hold and become a “complex pullback.”
At this point, I can exit the trade and reduce the complications.
Bear Traps vs. Short Selling
A bear is a financial market investor or trader who believes that the price of a security is about to fall. Bears may also believe that a financial market’s overall direction is deteriorating. A bearish investment strategy seeks to profit from a drop in the price of an asset, and a short position is frequently used to carry out this strategy.
A short position is a trading strategy in which you borrow shares or contracts of an asset from a broker using a margin account. The investor sells the borrowed instruments in order to repurchase them when the price falls, profiting from the drop. When a bearish investor misidentifies a price decline, the risk of being caught up in a Bear Trap rises.
To minimize losses, short sellers are forced to cover positions as prices rise. A subsequent increase in buying activity may spark further upside, fueling price momentum. The upward momentum of the asset tends to decrease after short-sellers purchase the instruments required to cover their short positions.
When the value of an index or stock continues to rise, a short seller risks maximizing the loss or triggering a margin call. Stop losses can be used to limit the damage caused by traps when executing market orders.
We are all caught up in trades. We may believe we’ve discovered something that the rest of the market is missing, only to have the market turn on us. Nobody can always avoid this fate, and there is nothing to be ashamed of. The difference is how we react when we are caught in a runaway trade.
Even if the stock gaps up and bypasses our stop loss, we still have control over our reaction. We can either admit that we made a bad trade and exit quickly, or we can try to test the fate of our accounts and “trade around” our position.
We usually do this because we do not want to admit defeat. These are the types of situations that turn a 2% account hit into a 10% account hit.