Many traders refer to insider lingo known among the financial community, but for others to understand these terms sometimes takes a little explanation.  A bear trap happens when the sentiment is that the market is going to turn downward but conversely, the prices reverse and go up.  We’ll go over bear traps and explain how you can make sure you aren’t falling into one in today’s blog article.

What is a Bear Trap in the World of Trading?

Not even the best traders in the world can predict every market move.  As trading systems have improved over time, systems and prediction algo’s have been created to help traders gain any edge possible in an effort to try to generate profits each day, week, month, and year.  While tools are out there to assist traders, there are also many traps set in place, which leads us to today’s topic: the bear trap.

The bear trap happens when the anticipated downward shift in prices al of a sudden take a sharp turn back up.  When this upward trend happens, the bear traps exists.  This is something that keeps both traders and investors on their toes, as most traders simply don’t have the ability to trade bear traps.  Most don’t know when they are about to fall into a bear trap, and, as they fall into the falling prices, they often times take out a short position as they feel the position will continue to fall, however, they are caught in a bear trap, and the price goes up.

How Does the Bear Trap Work?

The bear trap can happen most often when a group of traders sell all of their positions and wait until other traders are convinced that the market will continue moving south.  As the price action continues to go down, many traders will be convinced that the price action will continue to go that way, yet, they are wrong in this case.  The “trap” will be released and the market will move higher, and as a result, the ones who set the bear trap will profit while the ones who fell into it, will lose.

Bull Trap vs. Bear Trap

These can be confusing, and often times interchanged.  However, they are indeed opposite outcomes.  Unlike the bear trap which occurs when prices drop, the bull trap occurs when market prices go up and continue to move up.

What are the Causes of Bear Traps?

Bear traps can be caused for many reasons, including:

  • Long trends downward
  • Real life events that can’t be predicted (COVID is a classic example.)
  • A sustained upward trend

Identifying Bear Traps as a Trader

Traders can take some solace in knowing that there are ways they can identify and avoid bear traps.  There are three main thing to look for as a trader when trying to identify a bear trap:

  1.  Divergence – when there is divergence, there is a bear trap set.
  2.  Market Volume – watch out for drastic changes in market volume.  Low volume can mean there is a bear trap forming.
  3.  Fibonacci level – these indicate reversals in prices and can be a huge indicator for a bear trap.  When a price does NOT break a fibonacci level, this could indicate a bear trap.

How to Avoid Bear Traps While Trading

Trading comes with risk, but as always, knowledge is power.  Here are a few tips in closing that can help you avoid bear traps:

  1. Use candlestick patterns.
  2. Observe market volumes.
  3. Widen your stop loss orders.
  4.  Study the length of the downtrend.

Bear traps can lead to huge financial losses. If you are a trader, or someone who often takes short positions, you need to learn how to avoid bear traps at all costs.

James McCollum
About the author

James founded an investment club in the Northeast before many of the members started retiring and moving South. Along with his fellow investing enthusiasts, he continues to provide market commentary at Investors Circle.