What Is a Bear Trap in Trading?
A ‘Bear Trap’ is the name given to a misleading situation in the market where traders are enticed into entering short positions only for price to suddenly reverse and move in the opposite direction. In this article, we will explore the concept in detail, explain how to identify a bear trap, provide some examples and much more!
The information in this article is provided for educational purposes only and does not constitute financial advice. Consult a financial advisor before making investment decisions.
What Is a Bear Trap in Trading?
A bear trap in trading occurs when an asset which appears to have started a downward trend suddenly reverses course and rises in price.
Prompted by a bearish signal, traders enter short positions, expecting price to continue falling. However, the downward trend is not sustained and short sellers become caught in the bear trap, incurring losses as the price unexpectedly heads upwards once again.
Bear traps happen when market analysis sends you in the wrong direction. Amongst other things, the scenario highlights the importance of having a sound risk management strategy in place before entering the market. Although it should be noted that a risk management strategy does not eliminate the risks involved with trading.
Bull Traps
A bull trap is essentially the opposite phenomenon. Rather than traders being tricked by a downwards movement in price, a bull trap occurs when a signal implies that an asset’s price has begun an upward trend.
Traders, assuming that the asset will continue to rally, enter long positions, only for price to unexpectedly reverse and ensnare traders in the bull trap.
How to Identify Bear Traps
Identifying a bear trap is perhaps easier said than done. Often, it’s not until the trade has already gone wrong that it becomes apparent to traders that they have been trapped.
Market Analysis and Indicators
If a trader is to attempt to identify a bear trap, they should ideally combine various technical analysis tools and look for some kind of confirmation of a trend before entering the market.
Instead of entering the market based on one signal, such as price breaking through a historical level of resistance, traders should look to confirm the move to help avoid stumbling into a bear trap.
But how can you confirm such a move? One way might be to scrutinise trading volumes. If a downward price movement is not accompanied by an increase in trading volume, it suggests a lack of enthusiasm amongst market participants. As a consequence, the move may quickly fizzle out and potentially result in a bear trap.
Technical Indicators
Besides trading volumes, traders can also use technical indicators to attempt to confirm the existence of a trend or to identify conditions which may suggest an imminent reversal in price.
For example, indicators such as the Moving Average Convergence/Divergence (MACD) and moving averages can be used to help confirm a trend. Similarly, indicators such as the Relative Strength Index (RSI) and the Stochastic Oscillator can be used to help spot potential reversals in price, which might help traders avoid falling into bear traps.
Let’s take a look at an example using the RSI indicator. One of the ways in which the RSI can be used to spot potential reversals is by identifying a divergence between the price of an asset and the value of the RSI. Below is an hourly chart of BAE Systems, with the RSI added.
We can see above that, whilst the price of BAE Systems continues to move lower, the RSI starts to move in the opposite direction, recording higher lows. This divergence between the two can be a signal that there is about to be a change in price and, sure enough, shortly afterwards, the price of BAE jumps higher.
Patterns
Something else traders can keep an eye out for are candlestick patterns which sometimes occur on charts. There are a number of these patterns which, when identified, can indicate a potential reversal in price.
An example of a pattern which can appear at the end of a downtrend and signal a change in price to the upside is the bullish engulfing candle. A bullish engulfing candle can be observed when a bullish (green) candlestick follows a bearish (red) candlestick, with the body of the bullish candlestick completely engulfing the body of the previous candlestick.
In other words, the bullish candle must open lower and close higher than the bearish candle, as demonstrated in the image below.
Below is the same hourly chart of BAE Systems as examined earlier, except this time we have removed the RSI indicator and zoomed in on the point at which the downtrend ends.
At the bottom of the downtrend, we can observe a bullish engulfing pattern which is highlighted in red and marks the point at which the price reverses and starts to move higher.
Real-Life Examples of Bear Traps
Bear traps can occur in any market and on any time frame. In the following sections, we will take a look at two recent examples of what could have been bear traps for some traders. Please note that these examples are for illustrative purposes only.
Bear Trap Example 1: London Stock Exchange Group
Below is an hourly chart of the London Stock Exchange (LSE) Group, in which we can see that, after an uptrend, price starts to descend.
A bearish Marubozu candle is formed shortly after the downward movement starts, which can indicate that the price will continue falling.
However, shortly afterwards, LSE Group’s price shoots upwards, quickly erasing most of the downwards movement. Any traders who had entered short positions after seeing the bearish signal provided by the Marubozu candle may have been caught in the bear trap.
Bear Trap Example 2: Wizz Air
Our second bear trap example occurred in the hourly chart of Wizz Air, shown below.
The price trended downwards and, as before, a bearish Marubozu candle formed, indicating that the trend could continue in its downward direction. Nevertheless, the price quickly reverses, soars upwards and a new uptrend begins.
Any traders who were taken in by the bearish signal and opened short positions may have been caught out, losing their trades.
Risk Management Strategies for Bear Traps
As mentioned previously, bear traps can happen in any market and on any timeframe. Therefore, traders should ensure they design a risk management strategy which takes adequate steps to help mitigate the risk they pose.
Bear traps aside, risk management is an important part of trading, especially when using derivative products such as Contracts for Difference (CFDs) which are traded using leverage. Whilst leverage can magnify potential gains, it has the same magnifying effects on losses, meaning it must only be used with the utmost caution.
In the following sections, we will highlight some factors to consider when creating a risk management strategy.
Set a Stop Loss
Stop losses are commonly used in risk management.
Before entering a position, you should always quantify an acceptable level of risk for your trade and set a stop loss at the relevant level. By doing so, you can potentially limit the damage inflicted by a bear trap.
Position Sizing
As well as quantifying an acceptable level of risk, traders should consider limiting the size of any single trading position, which will help minimise any potential losses arising from a bad trade.
Monitoring Market Conditions
In addition to using stop losses and position sizes to minimise losses, traders should consider continuing to monitor the market after a trade has been placed.
Subsequently, should market conditions change or traders notice any sign of a potential price reversal, they have the option of exiting their position earlier without triggering their stop loss.
Hedging
Traders can also mitigate some of the risks presented by bear traps by using derivative products - such as CFDs, futures contracts and options - to hedge against adverse market movements.
Derivative products such as CFDs, futures and options are complex instruments and carry a high risk of losing money rapidly due to leverage.
Hedging involves a trader opening an opposing market position to their main trading position, with the goal of offsetting any losses in the main position with gains in the hedged position.
Final Thoughts
Bear traps in trading occur when traders enter short positions in an asset which is declining under the impression that this downward movement is set to continue. However, an unexpected reversal in price results in traders finding themselves in losing positions.
Bear traps are not always easy to spot until it’s too late. However, by paying attention to trading volumes, using technical analysis tools and continuing to monitor the market after opening a position, traders can potentially identify a reversal in price before it’s too late. Furthermore, by implementing a sound risk management strategy, traders can also help minimise any losses incurred by unexpected market movements.
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