Bear Trap

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 market 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 equities, bonds, 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.

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.

1. 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 portion 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 shareholders suffered huge losses due to the trap.
2. In April 2020, the COVID-19 crisis made many traders and experts believe that the financial market is entering a bearish 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.

In the TradingView chart given below, related to Aarti Industries, a Bear Trap is clearly visible. The prices are seen continuously falling because the novice investors are afraid to hold on to the stock after noticing a substantial fall. They keep on selling off their holding due to fear of further losses. This is the time when experienced traders come into the picture and start buying the stock in small quantities and at very less prices. The more the novice investors sell due to an anticipation of loss, the lower is the price of the stock, which facilitates experienced traders in their buying process.

But suddenly, there is an upmove in the stock, as shown in the chart below, with an excellent volume. This kind of situation often catches the sellers off-guard, who have been selling their holdings with the fear that the downtrend is here to continue. Thus, a perfect bear trap is formed that has been signaling a bearish market trend but has suddenly taken a reverse course and turned bullish, giving the opportunity to experienced traders to sell off their holdings that they have acquired at meager prices during the falling trend.

Source

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 positions 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.

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 –

• Bear Hug
• Bear Spread
• Bear Put Spread