A bear trap results in a stock that appears to be taking a turn for the worse, only to rebound quickly. It can be harmful to investors taking a short position in the market.
Plenty of people have lost money in the stock market, and one of the ways that happens is through a bear trap. A bear trap is where a stock’s price appears to be heading in one direction but suddenly starts moving the other way.
If you’ve never taken a short position on a stock, then you probably aren’t familiar with bear traps. However, it’s still important to understand the bear trap definition and how they work in the market.
What is a bear trap?
A bear trap is a pattern in a stock’s price where after trending upward, the price reverses course into a downward movement. However, this downturn is only temporary, and the stock’s price changes direction once again to start rising. While the eventual upward trend benefits many investors, it hurts those who made bearish investments (in other words, bet against the stock).
How do you find a bear trap in stock?
The Securities and Exchange Commission (SEC) identifies a bear market as a 20% decrease in stock prices over just a couple of months. Unfortunately, this is not always the case. It can be difficult to tell the difference between a bear trap and a longer-term drop in a stock’s price. You may be able to avoid a bear trap by paying attention to changes in the stock’s volume or technical indicators.
How does a bear trap work?
It’s natural that the stock market — and individual stocks within it — experience volatility and price fluctuations. While the stock market generally rises over the long term, there are plenty of times when it trends downward. A bearish investor may try to take advantage of those downward movements, often by taking a short position.
When an investor sells a stock short, they sell stock they don’t actually own. They use this tactic when they expect the stock price to fall since they can repurchase the same stock at a lower price. Then they can return the stock to its original owner and keep the profits.
The risk of short selling, of course, is that the stock price won’t actually fall as the investor expects. That’s exactly what happens in a bear trap. A sudden market movement causes a downturn in the stock’s price, leading bearish investors to sell short. But the price quickly reverses course, meaning the short sellers lose money.
How can a bear trap harm investors?
The losses in a bear trap can be especially large because short positions are often done with margin trading, meaning the short seller borrowed shares, often from their brokerage firm. Once the stock price increases and the broker sees the deal has lost money, they’ll issue a margin call, requiring the investor to pay back the loan.
Paying back the loan could be quite expensive, since the short seller has to repurchase the stock that has now increased in price, meaning they repurchase it for a higher price than they sold it for, with the difference coming out of their own pocket.
A bear trap can also harm novice investors who aren’t comfortable with the ups and downs of the market. When investors experience their first market downturn, they often panic sell their holdings, not realizing that’s exactly the wrong move. Unfortunately, they sell for a low price immediately before the stock prices rise. They’ve locked in their losses and have to pay more to repurchase their investment.
How to avoid a bear trap
A bear trap can result in huge losses for investors. Here are a few ways to avoid getting caught in one:
1. Don’t take a short position
The simplest way to avoid getting caught in a bear trap is to avoid taking short positions altogether. Selling a stock short is highly speculative and high-risk. It’s an advanced trading strategy and isn’t appropriate for most investors.
2. Use a different trading strategy
If you’re set on taking a bearish position on a stock, look for other strategies to do so. One of the dangers of selling short with a margin account is that your losses can be quite large. However, there are other ways to take a short position on a stock and still limit your potential losses. Those include options trading, stop-loss orders, and inverse ETFs.
3. Use advanced trading tools
Experienced traders who are interested in more advanced investing techniques, such as short positions, will want to consider brokerages and investment platforms that offer technical analysis and market research tools. Those tools, which include volume indicators, market indicators, and Fibonacci levels, can help you predict when a downward trend is a bear trap.
4. Think long-term
For most investors, the best strategy is a long-term one. When you’re just starting to invest, it can be easy to feel uncomfortable with the ups and downs of the market. And when you’ve purchased a stock that has a sudden drop in price, it can feel tempting to sell the stock and remove yourself from even greater loss.
The problem is that when you do that, you’ve locked in your losses. And when the stock price moves back up, it would be even more expensive for you to repurchase it. Instead, avoid making investment decisions based on the day-to-day fluctuations of the stock market.
How do you stop a bear trap?
Unfortunately, there’s nothing you can do to stop a bear trap. The best you can do is avoid getting caught in one. To avoid the negative effects of a bear trap, don’t take a short position on a stock or sell your holdings just because the price has dropped.
Bear trap example
Suppose you’ve been keeping your eye on Company XYZ’s stock, and after an upward trend, you see the stock’s price has started to slip. You’re convinced this is the start of a downward trend, so you decide to sell the stock short.
You use your margin account to borrow 100 shares from your broker at $50 per share to sell. You’re hoping the price will dip to $40 so you can turn around and repurchase those same shares for $10 per share cheaper. You would return the 100 shares to your broker and pocket the $10 per share — or $1,000 total — as profit.
But the price drop in Company XYZ’s stock doesn’t last long. Instead of falling to $40 per share as you hoped, the stock quickly rises to $55 per share and your broker issues a margin call. Instead of buying the stock back for $10 less per share than you sold it, you actually have to spend $5 more per share. And instead of a profit of $1,000, you have a loss of $500.
What is a bear trap in cryptocurrency?
A bear trap in cryptocurrency would look the same as one in the stock market. After experiencing an upward trend, the cryptocurrency’s price would suddenly reverse course and start moving downward. But the drop would be temporary, and the price would start rising once again after a brief period.
A major difference is that short selling isn’t a common strategy in cryptocurrency. Instead, bear traps often involve investors who sell a large number of coins to drive down its price and cause others to sell. Once the price has gone down, they repurchase the same coins at a lower price, resulting in a profit.
What is a bull trap?
The opposite of a bear trap is a bull trap, which works exactly the opposite. When a bull trap occurs, a stock that’s trending downward might experience a sudden increase in its price. But the increase is temporary, and the stock’s price eventually reverses course to trend downward again.
A bull trap is likely to be more harmful to the average investor than a bear trap. In the case of a bear trap, it’s often the bearish short sellers who are most harmed. And short selling isn’t a stock trading strategy that most investors use. However, many traders do buy with the goal of holding a stock for a longer period, only to sell it later for a profit. The trap can lure them in and make them think a stock is a good investment, only to have the stock’s price fall again after they’ve purchased it.
Bear trap vs. bull trap
An investor caught in a bull trap has more options than one caught in a bear trap. If you’ve sold shares short and a bear trap happens, you have no choice but to pay back your debts. And if you’re a novice investor who sold your shares because you were uncomfortable with the downward price trend, you’ve already locked in your losses.
But in bull traps, you have a couple of options. First, if you feel the stock’s price will never rebound, you can choose to sell your stock and lock in your losses. But if you feel the downturn is temporary and the stock’s price will eventually bounce back, you can take a long position and hold onto the stock.
- A bear trap occurs when the stock that had been trending upward has a sudden price reversal and starts dropping, but the decline is temporary and it quickly reverses course again.
- Bear traps can result in major losses for short-sellers, meaning those who bet against a stock by selling borrowed shares when they expect the price to drop.
- The opposite of a bear trap is a bull trap, which is when a downward trending stock temporarily starts trending upward, only to start dropping in price again shortly after.
- You can avoid bear traps by not taking a short position and taking a long-term approach to your investment portfolio.
View Article Sources
- Your Investment Options — New York State Office
- Types of Stock — Texas State Securities Board
- How To Invest In The Stock Market: 8 Basic Concepts — SuperMoney
- Best Online Brokers for Stock Trading in 2022 — SuperMoney
- Best Stock Trading Apps in 2022 — SuperMoney
- Brokerages: Reviews & Comparisons — SuperMoney