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What are bear traps in trading?

Sun Oct 10 2021 08:07
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Many investors can be very superstitious in today's market. This superstition often manifests itself in stock market traps. These stock market traps can significantly affect trading even when there is no reason or justification for their existence.
  
For that reason, any day trader needs to be careful of them for better investment choices.

But how do these traps come to be?

A trap in trading occurs when the market does not behave as a trader would expect it to. Typically, a trader uses a wide range of indicators to analyse the market to make better investment decisions. If the market performs contrary to the predictions made by the trader, it is considered a trap.

Traps in trading can be categorised into two primary categories: bull traps and bear traps. In this post, we will discuss more about bear traps.
So, what is a bear trap?

What are Bear Traps in Trading?

A bear trap definition, in trading, is a pattern that occurs when a stock’s or index’s price suggests a reversal in trend from downward to upward. According to technical experts, institutional traders set up bear traps to entice traders to take long positions.

If traders succeed in setting the bear trap, they can easily dump bigger stocks. Leading to a dramatic fall in prices.

Check out a bear trap stock example to learn more about how a bear trap works?

How does a Bear Trap Work?

Financial markets today are growing, with investors expecting to purchase stocks. And only a few sellers willing to accept their bids. In such a situation, investors might be forced to increase the amounts they are willing to pay for the stocks. 

When the buyer’s bids grow, more sellers would likely want a piece of the attractive prices. Therefore, they would flood into the market, causing it to move higher.

As you already know, an investor must sell the stocks to make profits. Therefore, these traders immediately put selling pressure on the stocks as soon as they acquire them. 

Naturally, a growth in selling pressure would result in a decrease in buying pressure, as many investors would have already bought stocks.

When such a situation occurs, institution traders may cut prices to stimulate demand and raise the prices of stocks, making the market appear bearish. When the demand rises, inexperienced investors will race to sell their stocks. 

Once the ‘amounts’ of stocks drop, seasoned investors would jump back into the market, leading to an increase in price in response to the rise in demands.

As we already mentioned, there are two primary types of stock market traps: bear traps and bull traps, among other subcategories. Such as two legged pullback traps. So, what's a bull trap?

A bull trap in trading is the opposite of a bear trap. It denotes a false signal where a decreasing trend in a stock or index reverses after a strong rally and breaks through a previous support level. This move traps novice traders and investors who acted on the purchase signal, resulting in long positions that lead to losses.

Causes of Bear Traps

A bear trap in trading can occur due to a variety of reasons – and can happen in any market. Although there are other causes, a bear catcher happens when institutional traders decide to lower or drag the prices down.

Here are other causes of bear traps in trading:
  • Long downtrend of prices in the market
  • Unpredicted real-life incidents involving prominent people
  • A consistent upswing in the market
A bear trap can significantly influence the market. For that reason, you have to know how to identify a bear trap pattern to make better trading decisions.

How to Identify a Bear Trap in trading

It is essential to identify a bear trap before you get caught in it as it minimizes the risk of losses when trading. If you are a seasoned investor, it can be relatively easier to identify a bear trap. 

However, you might need to check these technical indicators if you are a newbie.

Market Volume

Checking the market volume is one of the easiest ways to identify a bear trap. Ideally, there should be a considerable shift in the market when the price is possibly rising or falling. 

Therefore, you might be getting into a bear trap if there is no significant increase in volume as the price drops. Since bears can’t constantly bring the prices down, low market volumes are frequently used as a bear trap.

Divergence

Some indicators in the market provide divergence signals. As a trader, you should avoid trading when there is divergence, as that indicates a bear trap. But, how do you identify a divergence

Divergence is when the market price and the indicator go in opposite directions. That means there is no divergence when the market price and indicator move in the same direction – which means a bear trap would not develop.

Fibonacci Retracements

The Fibonacci level is another efficient indicator of a bear trap. Typically, trend reversals in the market are identified using Fibonacci ratios. Therefore, it is safe to say Fibonacci levels represent reversals of prices in the market – making them a good indicator of bear traps in trading. 

So, if the price or trends in the market do not breach any Fibonacci levels, it may mean you are looking at a bear trap chart.

How to Avoid a Bear Trap

A bear trap can cost you a lot of losses. Therefore, the best way to avoid the risk is to avoid falling into them. So, how do you avoid a bear trap?

Risk Management

Generally, there is no trading without risks. Anyone can run losses, even seasoned investors with years of experience. 

However, risk management in any trade is the best way to ensure you do not get hit where it hurts the most. While trading, ensure you do not invest more than you are willing to lose.

Check Indicators

There are many indicators that suggest a bear trap will occur. These volume and technical indicators can help you avoid the most painful bear trap. For instance, shorting can result in huge losses when the market rises again. 

Therefore, an intelligent trader should check indicators to avoid shorting.

Do not Ignore Technical Patterns

Most novice investors rush into purchases, ignoring the most prominent patterns that suggest they are falling into a trap. An intelligent trader would take time to analyse the patterns before taking investment risk. For instance, bear traps occur when there is a downtrend. 

Therefore, you should check the technical patterns to determine the length of the downtrend before you make an investment decision.

How to Trade Bear Traps

If you are a seasoned trader, you must know that you will encounter many bear traps while trading. Additionally, you can avoid the majority of them, but not all. 

You can easily fall into a bear trap even if all the indicators show otherwise. Therefore, it is essential to stay prepared for when you find yourself in a bear trap market.

There are multiple ways to survive a bear trap. However, timing is the key! The most sensible way to avoid any losses is to try spotting the bear trap before and withdrawing your profits before the reversals begin.

You can also get out of the bear traps as soon as you discover them. That is possible through the stop-loss order that can trigger as soon as an upward reversal is detected.

In conclusion

A bear trap can occur in any trade. Additionally, anyone can fall into them, whether a novice or seasoned trader. Luckily, you can avoid running losses by practising risk management and learning to analyse the trends/patterns in the market.
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