Bear trap in a nutshell
A situation in which investors who sold short near the bottom find themselves trapped when the market unexpectedly reverses ( going up ). When the market begins to rise,the shorts start buying which further fuels the upward price momentum and panic buying ( as known as FOMO ) for the remaining short-sellers who are still in the market. When the short covering is complete, the upward momentum slows and the market often resumes its downward trend. Its the opposite of Bull Trap. See Whipsaw.
In the market, a bear is an investor or trader who believes that the price will go down. A bear may also have sentiments that the overall direction of the capital market is headed downward. Bears, therefore, attempt to profit from a decline in the value of a particular security or the market in general.
A short is a trading technique that involves borrowing shares from a broker through account, selling the shares in the market, and buying back the shares when the price drops. A short is the opposite of a long position, which is the conventional investing practice in the financial markets. An investor who goes long on a security or market is typically a bull who believes that the security is going to increase in value, and therefore, hopes to take advantage of the future higher price by buying the security today. When the price goes up, the bull will sell for a profit. On the flip side, a bear would short a position to profit from any price fall.
Technical traders may be able to identify and avoid bear traps when the signals pop up on their charts. Using and understanding technical indicators like Fibonacci levels, Oscillators, and price and volume indicators could let a trader know whether the bearish trajectory of the market or security is legitimate or whether it’s a trap. Most investors who fall into a bear trap do so early in the trading session, and analyzing opening bell trends should indicate how often a particular investment falls in value early in the day, compared to later on.
Bear Trap Chart Example
Below is an example of a bear trap on 7/6 for the stock Agrium, Inc. (AGU). You will notice that the stock broke to fresh two-day lows, before having a sharp counter move higher.
How to Avoid Bear Traps
You will encounter many bear traps during your trading career. As we stated earlier, the key is not to fall into one. As you probably guess, it is impossible to avoid every bear trap; telltale signs you can lookout for in order to avoid these losing trades.
Market volume is one of the most important components for identifying bear traps. When a stock is starting to reverse, approaching new highs or new lows, you will notice volume beginning to accelerate.
However, what if the market changes direction and the volume is low? Watch out! This could be a bear trap!
This is the 10-minute chart of Twitter from Aug 26 – 27, 2015. The long black arrow defines the bullish trend. Suddenly, the trend line is broken and the price begins to decrease sharply, which is highlighted in the red circle. At the same time, volume is relatively low, which is a sign that the reversal is suspect at best.
So, is this a true reversal, or a bear trap?
After the break in trend, Twitter forms a base and then rallies back up to the recent peak.
Later, Twitter breaks the lower level of the blue triangle, thus giving the impression that the resistance area is too strong to be broken. However, the break through the triangle happens during low volumes like the previous break of the uptrend line. We have a second suspicious bearish breakout. Now what?
If you had shorted after the trend break or the triangle breakdown, you would have gotten yourself into a bear trap! Notice that the real stock moves occur during high volumes. These high volumes were absent during the two breakdowns, hence a bear trap developed.
Fibonacci ratios are crucial for identifying trend reversals. If the price doesn’t break key Fibonacci levels, you should assume the price reversal is in question. These sort of minor breaks should be perceived as trend corrections, but not true breakdowns.
Let’s now see how Fibonacci fits within the bearish trap scenario with Twitter.
Notice that after the trend interruption, Twitter finds strong support at the 23.6% Fibonacci Level. The next bottoms are not even close to this level. In our case, the price just bounces in the blue resistance. Then, the new rally appears.
Just as a rule of thumb, if a stock is unable to retrace 38.2% of the move, the primary trend is strong.
If you trade with indicators, which give you divergence signals, then you can easily spot bear traps. If the price breaks downwards, but the indicators account for a bullish undertone, then we should suspect the bearish move is likely a trap. It is not that important which indicator you use. It is important that this indicator provides divergence signals. In the image below, I will show you how to spot bear traps with the relative strength index and MACD.
This is the 10-minute chart of Bank of America from Nov 12 – 16, 2015. The blue lines indicate a trading range, which BAC was stuck in for the majority of the day. The red circle shows the breakdown in the blue channel. The blue lines indicate the divergence between the price and the two oscillators. The red line on the chart shows that the price is making lower lows, while at the same time the MACD and RSIare clearly moving upwards. This creates two bullish divergences between the price and the two indicators, despite the bearish breakout. This is a sign that a short position would not be a good move in this case. Let’s now see how the trade actually developed.
After the bearish breakout, the price starts a steady increase. This means that our breakout was indeed a bear trap. Fortunately, we managed to avoid the bear trap by spotting two divergences between price, RSI and the MACD.
Here we are again discussing the most important stock trading component = the price action!
If the price action were screaming a bearish trend is coming to an end, would you go short? Not me!
Have a look at the example below:
If your first thought was that you have seen this chart before, then you are right. This is the same Agrium Inc. chart we discussed at the beginning of the article. The new thing is the orange lines, which create a clear falling wedge formation. As you probably know, falling wedges after bearish trends lead to trend reversals. Thus, we expect the price to break through the upper level of the formation.
In our case, though, the price breaks through the lower level of the falling wedge figure we stay out of the market avoiding the bear trap.
When the price gets back to normal and breaks the upper level of the wedge, there is even a long position opportunity.
Let’s now go through another bear trap example, which we can avoid with simple price action knowledge:
This is the 30-minute chart of Google for the period Dec 9 – 17, 2015. This is another example of a bear trap stock chart, which could be easily recognized with simple price action techniques.
First, we have a falling wedge figure, which is outlined with the blue lines on the picture. We expect the price to break the falling wedge upwards, switching to bullish direction. Yet, Google breaks the falling wedge in a bearish direction, against the simple price action logic.
Even if we are lured into a short position here, we have a second chance to act wisely and to close the trade on time, when a hammer shows up four candles later. This is a famous reversal candle pattern, which signals an upcoming price increase. If we close our short position after this bullish signal, we will not only avoid big losses, we would also have generated a profit equal to $2.50 per share!
Note that this is not a good practice at all. Do not attempt to trade a reverse bear trap on purpose. If you get yourself into a bad trade, try to play your odds as best as possible in order to get out of the market unscathed.
How to Protest Yourself Against Bear Traps
Use stop loss orders!
If you enter a bear trap and you have an active stop loss order, what does this mean? This means that worst-case scenario you will lose no more than what you have planned to lose. Thus, your bear trap trade will not bankrupt you.
Bear trap charts source: tradingsim.com