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What is a Bear Trap?


illustration of a bear looking confused holding a bear trap

Bear Trap Definition 

A bear trap is a technical pattern that occurs when a financial instrument, such as a stock or index, incorrectly signals a reversal from an upward movement to a downward trend in price. This reversal indicates a shift from a bullish position to a bearish position; however, it is only temporary.


When a bear trap unfolds, it lures investors into initiating a short position on the asset, expecting a price decline. However, this anticipated downward movement is misleading. This technical configuration can manifest in various asset markets such as futures, bonds, equities, currencies, and cryptocurrencies. Investors who can adeptly identify bear traps and bull traps are better positioned to manage risks and make informed investment decisions.


illustration of someone about to stand in a bear trap

Bear Trap Explained with Examples 

A bear trap is a false signal that occurs when the performance of a stock, index or other financial instrument indicates a reversal of an upward trend. Investors, expecting downward market movement, short the underlying asset. However, due to the false nature of this reversal, the asset corrects and continues on the upside in a bullish manner, forcing many investors with short positions, bearish investors, to cover. 


As explained by NASDAQ, a bear trap can lead to short-sellers ‘being forced to cover at higher prices. If investors fall into a bear trap, they are at significant risk of losing money, depending upon their investment strategies and the time frame within which they are operating. A bear trap wrongly signals a reversal in price trend, which investors can interpret as a switch towards a bear market


An example of how a bear trap appears in charts is shown below using Twitter’s (TWTR) share price as an example: 


an example of a bear trap on a chart

[source: TradingSim]


Using Twitter as a case study, two instances of 'bear traps' indicate a misleading reversal in the asset's price ascent. Investors who misread these cues may establish short positions expecting a price drop. Such actions temporarily increase buying pressure, which boosts trading volume. Yet, as depicted in the chart, these bear traps represent deceptive price actions, soon corrected by the resumption of a bullish trend.


Conversely, a bull trap occurs when investors purchase an asset that is declining or priced low, misled by what appears to be an emerging bullish trend. Investors buying during this perceived uptick fall into the trap of believing that this brief rise in price signals the end of a downward trend, similar to the dynamics of a bear trap. However, this is merely a transient price fluctuation and not a trend reversal. Investors who take long positions, hoping to capitalize on what they perceive as undervalued asset prices, stand to lose money if the asset’s price continues its downward trajectory.


An example of a bull trap is shown below:


an example of a bull trap

[source: IG.com]


Bull Trap vs. Bear Trap


Similar to a bear trap, investors also face financial risks when they invest long in an asset that turns out to be a bull trap. Both bear and bull traps frequently occur in asset markets due to price volatility. The surge in retail investing and the popularity of 'meme stocks' have exacerbated this volatility, leading to more frequent bear and bull traps that can catch retail investors off guard. The key distinctions between these two traps are outlined below:

Bull Trap

Bear Trap

A temporary rise in stock price/upward movement/breakout.

Temporary fall in stock price/ downward trend movement.

Investors go ‘long’ on the asset-buying what seems to be a discounted/low asset price.

Investors go ‘short’ on the asset, selling what seems to be a high price for the asset.

 Investors anticipate a bullish trend and a move towards a bull market.

Investors anticipate a bearish trend and a move towards a bear market.


bear vs bull in trading

 

What does it Mean for Retail Investors?


For investors, recognising the potential pitfalls of misreading market signals is crucial for developing safe and effective investment strategies. While long-term holders of assets are generally less susceptible to bull and bear traps, it's essential to understand how to identify these traps and be aware of the risks they pose.


Conducting thorough due diligence that extends beyond just technical analysis is key for investors aiming to sidestep these common pitfalls. Gaining a deeper understanding of the broader social, political, and economic factors that influence an asset's price can enrich an investor's knowledge of the asset and the market at large.


Additionally, engaging with communities that share insights on technical analysis, external news, and diverse perspectives can be enlightening. However, it's important to approach information from public forums, discussions, or groups on platforms like Etoro with a healthy dose of skepticism. A comprehensive understanding of the market dynamics and the assets being invested in, coupled with a keen awareness of the risks associated with bear and bull traps, will enhance an investor's decision-making and overall investment acumen.





Key Points 


  • A bear trap is a technical pattern that occurs when a financial instrument falsely signals a reversal in price movement from an upward trend to a downward movement.

  • Investors that fall into a bear trap risk losing money from shorting an asset in the hope that the price will continue to fall. 

  • Conversely, the opposite can occur in the case of a bull trap when a temporary upward movement in price leads to investors taking long positions, only for the price to fall. 

  • Both bear and bull traps are common within the stock market daily; investors are more at risk of these traps when trading over short periods and in volatile assets. 


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