The unexpected market situation in which the market initially goes down and then goes up is called a bear trap. This type of trend reversal has been witnessed by almost every trader.
A bear market is a situation in which the market starts to go down. However, in a bear trap, the market seems to go down before actually going up. That’s why this situation is called a bear trap. This type of trend can happen in any financial market, even in the crypto market.
Most bear traps are successful in deceiving new investors. However, experienced traders always use the right tools to identify a bear trap before it affects their portfolio.
The market sentiment is indicated by the terms bull and bear, especially in the financial markets. When more people are buying assets and the market is going up, the situation is called a bull market. On the other hand, when more investors are selling their holdings instead of buying more, the market is called a bearish market.
Since traders always respond to both types of markets, you will always see lots of trade happening no matter what the market situation might be. Bearish market trades work by selling short and making a profit on the trade.
However, sometimes market uptrends suddenly stop making any progress. Desperate bear traders will hop to put sell orders as they think the market is preparing to go into a bearish mode. This way, the bear trader starts waiting for the market to crash in order to buy the same asset for less money. However, instead of going down, the market starts to rise again and goes into a bull mode. This is called a bear trap, and it proves to be devastating for desperate short sellers who place their sell orders too soon.
Bear traps mostly occur around the support line. The market stops or starts to reverse quickly. This trend reversal is followed by another reversal which happens within the next five candlesticks. The market starts to regain its momentum and goes into bull mode once again. Stocks with a reasonable price can also be traded by many traders, thus increasing the chances of bear traps.
Working of Bear Traps
In a bear trap, the price of a coin starts to decrease in the midst of a bullish run. This causes a sudden drop in the price of the asset as well. This causes traders to lose their money around the globe. At this point, bullish traders try to place short orders to minimize their loss, and bearish traders try to short the asset to buy it back later on for less price. However, since we are in a bear trap, the market will suddenly reverse its trend once again and will start going up.
Bear traps can be used by traders to short sell an asset. In short selling, you sell an asset for a high price whenever there’s a bearish market trend predicted and buy back the same amount of asset for less money when the market goes significantly down. In a bear trap situation, you can borrow the assets on a margin to trade/ short sell them. In a nutshell, you sell your assets when the price starts to go down and buy them back at a lower price point.
However, keep in mind that this type of shorting is very dangerous when the market is in a bear trap. Whenever the market reverses and starts to go up once again, you will need to buy the exits for more money to maintain your margin. In the case of a bear trap, bearish traders and short-sellers suffer from more loss than bullish traders.
In order to separate a bear trap from a genuine market reversal, traders use lots of different methods and tools. Moreover, you can avoid most bear traps by thinking twice before placing short selling orders in a bullish market that has just stopped near the support line. Always use other parameters as well to determine what has caused this type of instant reversal before placing any trades. If the market reversal is unexplainable, it is definitely a bear trap, and you should avoid trading it at all costs.
You can also use the market volume in order to easily track a bear trap. Market volumes usually change when shares reach a new high price point or a new low price point. These types of situations can cause a sudden sentiment change to reverse the market. However, if a bearish market happens without a solid reason or a significant change in market volume, then it is surely a bear trap.
You can also use tools like Fibonacci bands to spot bear traps. If the market has reversed without crossing important Fibonacci lines, then the reversal in the bullish market usually lasts for a short period of time. Always take a look at the indicators you use when a bullish market suddenly reverses. This will keep you safe from significant losses during bear traps.
Because of the short-term trades made by traders to benefit from a bear trap, the market starts to recover soon after getting hit by the trap. Moreover, once more traders realize that the bearish run was nothing but a bear trap, they start to support the bullish trend as well. This trend of recovery is very strong and significantly affects any short sellers who miscalculated the market.
Identifying a Bear Trap
Bear traps cause traders to lose a lot of money. Therefore, as a trader, you should know how to identify a bear trap if you want to avoid it most of the time. Here are some of the best tips you can follow to identify a bear trap.
Separation
Using some specific indicators to avoid falling into bear traps can provide you with useful signals to avoid them. If the indicator is moving opposite to the market price, you can say that the market is entering a bear trap.
By using useful indicators to identify any type of market separation early, you can easily avoid falling into a bear trap. However, when there is no divergence in the market, you can say that the market is not going through a bear trap.
Fibonacci Bands
This indicator is used to spot any type of trend reversal in the market by using specific ratios. Fibonacci levels are one of the best indicators of bear traps. Whenever a trend reversal happens, which does not break any of the Fibonacci levels, there will be no bear trap ahead.
Market Volume
Market volume is one of the biggest indicators of bear traps. Whenever a strong rising or dropping trend happens, it affects the market volume of an asset significantly. On the other hand, if the price of an asset drops without a significant change in its market volume, then the market is just going through a bear trap. Low trade volume also indicates a bear trap since it can’t keep the price of an asset down for much longer.
Techniques to Avoid Bear Traps
No matter how experienced you might become, it isn’t practically possible to avoid bear traps 100% of the time. However, you can avoid most of these traps by using effective measures. Here are some steps you can take to avoid bear traps most of the time.
Always Use Stop Loss
Using a stop loss can always help you survive in a Bear trap. Keep in mind that placing large stop loss orders can’t stop a bear trap from happening because stop loss is always away from the market.
However, the market reversal and coming back down once again can take a long time to happen. This way, your benefit will be significantly delayed. In another case, the price might not recover at all.
Wait for the Market To Stabilize
If the market is going down and you want to benefit by selling short, you should actually wait and see what happens before hopping onto the opportunity. So, in a nutshell, you should never decide on your trades in a hurry and should always wait before placing sell orders if you suspect that the market is going into a bear trap.
You should always wait for the market price to consolidate before trading any further.
Keep a Close Eye on the Market
Whenever the market reaches a breakout point, you should wait and see for some time to analyze the trends and see how the market fares. No matter if it is a support or resistance breakout, you should always show patience because there might not be enough momentum in the market to continue the trend at that point. This is the mindset of a mature trader, and it has the potential to keep you away from significant losses.
However, if the market has been sluggish in reaching a support level, you can trade the breakout without much fear. In situations like these, the sluggish drop in price indicates that there was enough momentum in the price to keep going further down than the breakout point. So, while there’s still some degree of risk present, the scenario isn’t nearly as dangerous as getting trapped in a bear trap is.
While trading, you should always be reluctant to place buying or selling orders. Always analyze the market before making any decisions to avoid significant financial losses.
Go After the Bigger Trends
If they break out in a specific market that is not towards the bigger trend that the market has been following for the past few days or weeks, you should be reluctant to place any orders against the bigger trend. Bear traps are formed through this method, and you should always avoid them as buyers will soon rush to the market to continue the former trend.
Wait For 2 Candlesticks
If you are selling, you might still sell on the support level breakout. However, if the candlesticks forming immediately after this trend are bullish and lack momentum, you should immediately take profits.
Whenever you see the indicator of a bear trap, you should do the exact opposite. You should start buying at the new and temporarily low price and wait for the market to bounce once again.
While buying under these circumstances still has its own risks, you’ll also be enjoying a big profit if the market goes up quickly, which happens nine times out of ten. So, it definitely is a risk worth taking.
Risk Management
Practicing discipline when managing your trading risk can help keep your account away from significant losses. A well-disciplined trader uses stop-loss, and manages the risk in such a way that no trade, no matter if it is a Bear trap or not, can damage their portfolio beyond a certain point.
Whenever you’re short selling, you’re guaranteed to come across a bear trap sooner or later. Therefore, you should plan ahead to avoid getting caught in bad positions. You can always use stop-loss on every trade and take any additional steps necessary to contain the risk in each trade you make. Even with all the knowledge and strategies, you should keep in mind that the average winning percentage for traders is around 60%. So, be ready to lose on some trades as well.
You should only use around 1.5% of your total portfolio per trade. Since this number is low as compared to your portfolio, your chances of panicking will decrease significantly. Position sizing is one of the most important parts of placing winning trades.
If you don’t use stop loss in a bear trap, it will damage your account significantly. Traders tend to keep trying to get the most out of their loss rather than quickly exiting their position, which is a rational approach to dealing with bear traps. That’s because of how hard you try, the market will keep rallying after bouncing back, and your loss will become deeper.
After exiting a position, you can analyze the market and time your next trade carefully. This is the right way of trading rather than keeping maxed-out loss positions open. The strategy here is saving your money to later keep playing in the market, which is always more important than short-term benefits.
Never Ignore Big Patterns
Whenever you’re at a loss in trading, it’s because of your own actions. Small losses can trigger novice traders to start panicking and placing even more trades without proper risk management. This causes them to ignore the discipline and risk management required to stop significant losses. This makes for a perfect recipe for disaster.
Therefore, you should never ignore the big picture and long-lasting trends only to place trades emotionally, as this definitely causes huge losses.
Respect the Bullish Momentum
Every market has its own expansion and contraction periods. The range contraction is the period when there isn’t much momentum in the market, and the stock sits idle. In range expansion phases, when the market is showing momentum upward, events like bear traps are very common. However, these come when no one expects them.
When the market is moving with lots of momentum, you can clearly identify the type of trade that is controlling the market. As a short seller, one shouldn’t ignore the clear bullish momentum in any market, as that’ll only lead to more loss. Whenever a new momentum wave is starting, you should stay analytical the whole first red day. This is the best way to analyze a market before making any trades.
Large investors take multiple days to establish their positions on a stock. Therefore, they buy every dip along the way. This is why short sellers should be weary of any dips within the bullish/ upward momentum in any market.
Takeaway
Bear traps are short-lived reversal trends in bullish markets, and they arrive at the least expected of times. Whenever a bear trap starts, any trader who shorts the asset is sure to incur a loss whenever the market heals. Bear traps are very common in every financial market, like bonds, equities, currency, and futures. This trend specifically traps short sellers, and although it is a tricky situation for bullish traders as well, it causes less loss for them.
As a short trader, you can always rely on certain market indicators and graph analysis to see if you’re under a bear trap or not. While you can’t keep yourself away from bear traps 100% of the time, the loss can be minimized by using stop-loss on every trade you place. Bull traps are the exact opposite of bear traps, and they target bullish traders.
While no trader, whether experienced or not, can always avoid a bear trap, you can always minimize the risk by using the right trading technique and tools. Moreover, you should learn to discipline your trades and use only a small percentage of your portfolio (around 1.5% per trade) to keep the loss under control.