Bear Trap: Definition, Example, & How To Avoid
A bear trap can cause bearish investors to lose money. Find out how these technical patterns occur and how investors can prevent themselves from getting lured into the trap.
What Is a Bear Trap and How Does It Work?
A bear trap, or bear trap pattern, is a sudden downward price movement, luring bearish investors to sell an investment short, followed by a price reversal back upward. Short sellers lose money when prices rise, triggering a margin call or forcing the short seller to cover their position by buying back borrowed shares.
Note: Since a bear trap is a short-term pattern associated with technical trading, it's not a suitable strategy for long-term, buy-and-hold investors.
Bear Trap vs. Bull Trap
A bear trap and a bull trap are similar in that they both involve a false signal indicating a break in a trend, followed by a reversal that returns back to the original trend. In both instances, the investor or trader incurs a short-term loss. Where bear traps and bull traps differ is that the direction of the trends and reversals are opposite.
- Bear Trap: After an upward trend in price, a sudden break downward in price below a key support level sends a false bearish signal, luring bearish traders to sell short, only to be followed by a reversal upward in price.
- Bull Trap: After a downward trend in price, a sudden break upward in price above a key resistance level sends a false bullish signal, luring bullish traders to enter long positions, only to be followed by a reversal downward in price.
Bear Trap vs. Short Sale
A bear trap involves short selling of a stock or other investment security. However, a bear trap and short sale are not the same thing. A decline in price triggers a bearish investor into a short sale, which can make the investor money if the price continues to fall. However, the quick reversal back up in price causes the short seller to lose money.
Note: Short selling, or to "sell short," means that an investor, or short seller, borrows shares/units of an investment security, usually from a broker, and sells the borrowed security, expecting that the share price will fall. If the share price does fall, the investor buys those same shares/units back at a lower price and can make a profit. If the price of the security rises after the short sale, the short seller may be forced to cover the sale by purchasing the shares back at a higher price, causing the short seller to lose money.
Causes of a Bear Trap
What causes a bear trap is not just the downward price movement but a drop in price below a key support level. The bearish investor or trader expects a break downward through a resistance level to be followed by further downward movement. Thus, they are "trapped" and lose money after the reversal in price back upward.
The causes of a bear trap are:
- Drop in price below a key support level
- Investor or trader enters into a short position
- Drop below the support level is brief and followed by a reversal upward in price
Bear Trap Stock Chart Example
For a bear trap chart example, consider a scenario where traders were watching a key support level of $425 on the SPDR S&P 500 ETF (SPY), a US stock market proxy. Thinking that a break below this support was a bearish signal, some traders shorted stocks. However, the price reversed, causing short sellers to lose money.
Ways to Avoid a Bear Trap
The only reliable way a trader can avoid a bear trap is to avoid entering into a short position altogether. But there are alternatives to short selling, such as put options, or ways to avoid certain situations, such as low trading volume, when bear traps are more likely to occur.
Ways to avoid a bear trap are:
- Avoid short positions when trading volume is low for the investment security. Bear trap risk can increase when volume is low.
- Use alternative trading strategies that can limit losses, such as buying put options. In theory, there is no limit to losses with short selling.
- Advanced traders may use Fibonacci levels, which involves a technical analysis method that can help a trader determine support and resistance levels.
- Avoid entering into a short position altogether.
A bear trap can be caused by a decline in an investment security's price, triggering some bearish investors to open short sales, which then lose value when the price action reverses course and rises again. A bear trap pattern involves technical trading and is not a suitable strategy for long-term investors.
A bull trap occurs when a downward trend in a stock or other investment security breaks upward and above a key resistance level. The break above the support level lures bullish investors into buying shares of the investment. The price reverses, causing the bullish investor to experience a price decline.
A bear trap can be identified by the price of an investment security that falls below a key support level, where bearish investors enter short positions. The downward trend then reverses back upward, "trapping" the unsuspecting bear into a losing position.
The initial price action that leads to a bear trap can take weeks or months to establish but the bear trap itself, or the point where the price breaks through a support level and reverses course back upward, can be almost instantaneous.
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