Bear Trap Trading: A Beginner’s Guide

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A bear trap occurs when the market begins trading lower and gives every indication that this might continue. Investors who want to profit from this move establish short positions in stocks and/or indexes, which move up in value when the underlying securities fall in price. This is the “bearish” portion of the bear trap, as bear markets are those in which prices fall.

The “trap” portion of the bear trap occurs shortly after, when the market suddenly reverses course and begins trading higher. This creates financial losses for all of the bearish traders who established short positions in the belief that the market — or individual stocks — would continue trading lower.

Real-World Example: Tesla

Tesla is often cited as an example of a stock with multiple bear trap events. Every time the shorts take the stock lower, it seems to comeback even higher.

One such instance was from Feb. 28 to May 31, 2023. On Feb. 28, the stock traded at $207.46, but it fell sharply to $164.31 by Apr. 2, according to data from TradingView. Those who established short positions at that point got whipsawed, as the stock immediately reversed sharply higher, reaching $203.93 by Apr. 30 and $261.77 by May 31.

What Causes a Bear Trap?

Bear traps are prevalent in all markets and asset classes. Any security that changes in price has the potential to create a bear trap scenario at some point or another. There several factors that can contribute to a bear trap:

Market Sentiment

Generally, bear traps begin when market sentiment sours on a particular stock, industry, or even the market as a whole. This could look like:

• Market participants believe that a stock or market is overvalued, so the security begins to lose value.
• Investors start selling a security at a gain, but so many are selling that the security begins to lose value. This is known as profit-taking.

Selloffs or Market Corrections

Selloffs or market corrections cause securities to drop in price, but the price often starts to go back up. Believing that any drop in prices is the start of a bear market can result in falling into a bear trap.

Technical Analysis

Technical analysis uses the past performance of stocks and indexes to project trends and future price action.

But technical analysis isn’t always right, and investors can also misread charts and find patterns where there are none.

What Does a Bear Trap Look Like on a Chart?

Here is the sequence of events leading to a bear trap on a chart:

• Initial price drop As soon as the price of an asset declines, traders begin looking for signs that a bear market is setting in.
• False breakout: As the price drops further, traders are convinced that the bear market has arrived, and they begin setting up short positions.
• Reversal: When the downtrend is proven false and prices quickly reverse higher, traders with short positions are caught in the bear trap.

You can recognize a false breakout by looking at its candlestick formation. A candlestick chart displays the high, low, open and close prices of an asset in graphic form.

Of course, understanding and analyzing all of these patterns takes time and research — and they’re not always 100% accurate either.

Real-World Example: Bitcoin

To illustrate that bear traps can occur in varying asset classes, here’s a look at what happened to Bitcoin in March 2023. The volatile cryptocurrency had a huge reversal, falling from $25,000 in February to below $20,000 in early March, according to The Trading Analyst.

This was seen by many as confirmation that Bitcoin was in trouble and heading lower. But those who sold or went short regretted this just four days later, when the crypto sharply reversed and surged more than 70% within a month, hitting the $31,000 area.

Strategies To Avoid Bear Traps

Even the best traders can fall victim to a bear trap. Here are the strategies you should employ to reduce your risk:

Set Stop-Loss Orders

Stop-loss orders can help protect the money you’ve invested. You can set them so that the stock will automatically be sold off if it drops to a certain value. It gives you a layer of protection and prevents you from having to check your investments everyday.

Avoid Over-Leveraging Positions

Over-leveraging means that you’ve invested more money than you can afford to lose. No matter how confident you are in the market, it’s impossible to predict what it will do. Never over-leverage yourself.

How Can You Make Sure You Don’t Fall Into a Bear Trap?

Before you sell, make sure you look for as many signs that the asset is going into a long pattern of decline.

Use multiple forms of technical analysis to confirm your belief and cross-verify them with fundamental analysis as well. For example, if a stock reports terrible earnings and gives a bleak outlook for its future, it’s a good sign that shares will continue trading lower.

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