Investors always hear about bull markets, bear markets, and everything in between. Bull markets are markets where sentiment is positive towards buying, and stock prices are rising. Meanwhile, bear markets are markets where sentiment is negative towards selling and stock prices are falling. Often during these markets, investors can make the mistake of thinking the market is telling them one thing when really, it’s doing the other. In other words, they can outsmart themselves into getting caught in a trap. Bear traps are temporary reversals in market trends that can lure investors in and then cause deeper losses afterward.
What is a Bear Trap?
A bear trap is a technical pattern that commonly occurs when a stock or broader index misleadingly reverses after trending upwards. These patterns can often trick and lure investors into shorting based on anticipated downwards price movements that never end up happening.
Bear traps work in a simple yet complex way. They prompt investors to expect a decline in a stock or the market. This, in turn, causes them to speculate on a decline by initiating short positions. If the asset which was sold short stays flat or rallies, the investor takes a loss. While some investors sell a declining asset to keep some profits, other more bearish investors will short that same declining asset. In this case, their intention is to profit and repurchase it once the price declines to a certain level. But if that trend downwards never happens or briefly reverses, the price reversal is identified as a bear trap.
Bear traps can be deliberately caused by big institutional investors. In these cases, the purpose is to trick smaller traders into thinking that there is an opportunity to short. Once enough short sellers initiate positions, they then lure you in and start going long, reversing price movements.
They can work in several ways. Two of the most common are the support level bear trap and the volume level bear trap. The former trap happens when the price hits a support level or briefly breaks it and then reverses upwards. The latter occurs in the same exact way. However, it’s based on volume rather than support.
How to Identify a Bear Trap
There are several ways to identify a bear trap. One way is through identifying support levels. Another is through identifying moving averages. A third one is through analyzing stock moves based on volume. Whenever stocks begin a reversal towards new highs or new lows, the volume will accelerate. But when the market changes direction and the volume is low, it could always be a bear trap. Investors most commonly use technical patterns to analyze and evaluate market trends.
Indicators That Can Help Identify Them
Tools such as Fibonacci retracements, relative strength oscillators, and volume indicators, for example, can aid investors’ technical analysis. They help predict the sustainability of upwards or downwards trends. The Aroon indicator especially is a popular technical indicator used to identify price trends and the strengths of those trends.
Aroon indicator strategies signal when there is a strong uptrend or downtrend and detect the legitimacy in trend changes. The Aroon indicator is composed of two lines. The up line measures the number of periods since a High. The down line measures the number of periods since a Low. Typically, the Aroon indicator analyzes 25 periods of data. When the up line is above the down line, it indicates bullish behavior. Meanwhile, bearish price behavior is signaled when the down line is above the up line. When the lines cross, it means that a new trend is starting.
While the Aroon is a moving average tool that uses price changes for its technical analysis, it has a key difference. The timing it’s based on compares the last high to the last low. It operates on a scale of 0 and 100. For example, if the Aroon up at 100, that means the asset has not made a new high since the start of the period. If it’s down is at 0, that means the asset has not made a new low since the start of the period. Usually, investors focus on the 30 and 70 levels. That’s because those two show when the last high or low occurred in the most recent third of the time period.
Examples of Bear Traps
As mentioned before, bear traps can happen with all financial instruments, whether it is a stock or index. Another instrument where they can often happen is the futures contract. A futures contract is a legal agreement to buy or sell something at a fixed price at a specific time in the future between two parties. Futures contracts can involve anything from a stock index to crude oil to live cattle. They can trade almost 24 hours a day, such as the example below.
Below is a chart of a Dow Jones Futures contract from 2013.
This chart depicts the specific futures contract in question using 15-minute periods. The starting date on the chart is 9:30PM EST on August 8th. The other end of it the Friday close on August 9th at 5PM. Depicting how volatile futures trading can be, this chart also shows a bull trap around the red shaded rectangle on top of the chart.
Let’s focus on the bear trap around the green area. As the Dow moved lower than the early morning lows from 6:15 am to 8:45 am, those who bought the contract at higher prices panicked and sold. Meanwhile, others tried to profit off the drop by shorting. While the abundance of sell orders and shorts caused a sharp drop, more buyers entered the markets than sellers. The result was a sharp reversal of the market, pushing it higher. It then rallied 104 points from the lows of the day.
Below is another bear trap example with a futures contract. This is a very recent example involving oil back in April. As everyone remembers, oil was arguably the most volatile commodity during the COVID crashes of March and April. It even briefly turned negative for a period of time. While many people profited off shorting oil futures contracts, many also lost a lot of money during the subsequent recovery. If there was ever a perfect example of a bear trap, it would be this chart of an April 2020 futures contract for crude oil.
While April 2020 futures contracts for oil moved to negative prices, notice how volume ticked up significantly when oil bottomed out. Before a stock or commodity starts a reversal, the volume will accelerate. When the asset changes direction and the volume is low, it could always be a bear trap. Notice how oil has a bearish trend here. However, look at when the reversal starts. It happens when volume ticks up to its peak. After this futures contract bottomed, notice how and when it starts the reversal. May witnessed oil’s price jumps by nearly 90%. It was the largest gain in history.
Illustrated below is another bear trap example with a stock. The chart below is for the agricultural products and services retailer Agrium, Inc. (AGU). Notice from this chart that the stock broke to fresh two-day lows and appeared on the surface to trend downwards before taking a sharp turn upwards. This is a perfect example of a support level bear trap.
Below is another example of a bear trap with Twitter (TWTR).
This is an excellent illustration of a market volume bear trap. When a stock is starting to reverse, approaching new highs or new lows, the volume will accelerate. But when the market changes direction and the volume is low, this could always be a bear trap. Notice how in both traps on the chart, the stock still has a bullish trend, defined by the long black arrow. Suddenly, the trend line is broken, and the price begins to sharply decrease. But notice the volume below the cart. Volume is relatively low, which shows that the reversal may not be a truthful indicator of a reversing long-term trend.
Here is another example on the GBP/USD FX rate chart. We can see both a support bear trap and a moving average bear trap in the chart below.
The first bear trap on this chart is a support level trap. On this daily chart, GBP/USD is trending bullishly with a support level around 1.25. Once it retraced lower, from there, it bounced higher to 1.28. Once it dropped further, and briefly below the support level, it sharply reversed back above it, closing with a hammer candlestick, a bullish signal. Eventually, GBP/USD continued the bullish trend, eclipsing 1.33.
The next two on the above chart are both moving average bear traps. Moving averages can work as support or resistance when they are horizontal. Alternatively, as trend line support when they are moving upwards. In this example, the moving averages are horizontal and are at the forefront of the bear traps.
What Makes Bear Traps Happen?
Bear traps happen when there is a sharp decline in a financial instrument that lures investors into opening short sales. These short sales lose value in a reversal when short sellers are forced to go long to cover. Short sellers risk maximizing their losses when they bet against a security or index and that security or index rises.
Can You Trade During a Bear Trap?
It’s always possible to trade during a bear trap. In fact, they are largely technical events that are caused by traders. But just as with bull traps, investors should always be cautious, mindful, and analyze all of the technical indicators that they can. Avoiding bear traps will increase your odds of earning a profit. However, there will be times you open new positions, and you can still fall into them without realizing it. With more risk comes more reward. This simply a fact of life in investing. Short selling is one of the riskiest methods of selling, with one of the most lucrative rewards. In particular, bearish investors need to be extra cautious when initiating a short position because it will likely attract many other bearish investors looking to profit from that same short position.
Trading a Bear Trap
While many believe that investing in a bear market is counterintuitive, bear markets offer significant opportunities to either buy low or profit from shorting. Generally, a bear market is when a stock or index falls by 20% or more from their most recent high. Investors either find opportunities to go long on stocks attractively priced and start buying, or predict that they will go lower and go short. Depending on the amount of activity, either long or short, the markets will either go lower, officially continuing the bear market, or go higher, officially starting a bear trap.
As briefly touched on before, investors can use multiple technical trading tools such as the Aroon indicator, Fibonacci retracements, relative strength oscillator, volume indicators, and more to distinguish a bear trap from a genuine trend reversal. Before trading a bear trap, it is crucial to look at the technicals. If a strong bullish trend suddenly and suspiciously moves downwards, you should analyze certain market factors instead of jumping in to answer several questions. Why did this reversal happen? Is there a meaningful change in market sentiment? What is the trading volume like?
Using the Aroon
The Aroon indicator was touched on earlier and is a good first step to analyze how legitimate a trend is. In other words, this indicator can give an investor tools to see if they are trading a genuine trend reversal or a bear trap. The Aroon indicator signals when there is a strong uptrend or downtrend. Through its upper and lower lines, it also detects how genuine a trend reversal is. Typically, the indicator analyzes 25 periods of data and is based on timing that compares the last high to the last low. The Aroon indicator operates on a 0-100 range, with 0 meaning that the asset has not made a new high since the start of the period. The 30 and 70 levels usually show investors that the last high or low occurred in the most recent third of the time period.
Other Indicators You Can Use
Fibonacci retracements, or bands, are another important technical tool that can warn investors of an approaching bear trap. If the share price does not cross critical Fibonacci lines, then the trend reversal is probably temporary.
The relative strength oscillator, or Relative Strength Index (RSI), is another critical technical tool that can warn investors of bear traps. This technical tool is a momentum oscillator that measures the speed and change of price movements. Like the Aroon indicator, the RSI oscillates between zero and 100. When the RSI is above 70, it is traditionally considered overbought, and when it’s below 30, it is considered oversold.
As discussed earlier, the market volume is also a critical indicator that can help identify bear traps. When a stock is starting to reverse, approaching new highs or new lows, the volume will accelerate. But when the market changes direction and the volume is low, it could be a trap.
Behavioral finance can also be a valuable tool when trading bear markets. Understanding human behavior and the psychology of markets can go an exceptionally long way in trading bear traps. People are emotional beings by nature, and markets move based on forces of extreme and often irrational sentiments. Behavioral finance is a concept becoming increasingly adopted and states that people make costly mistakes with their money due to emotional biases, cognitive errors, and lack of discipline. By staying disciplined and stable without being reckless with market moves, investors can more successfully avoid bear traps and trade successfully.
Risk of Trading a Bear Trap
There are many ways to successfully trade a bear market and thus trade a bear trap. However, there are many risks to be mindful of. Bear markets indeed offer several attractive opportunities for savvy investors. However, just as bull market investors always have a bull trap risk, bear market investors always run the risk of getting caught.
While jumping long into a plunging market, of course, poses the risk of incurring further losses and “catching a falling knife,” shorting these bear markets potentially offers double the reward yet double the risk. If you start shorting a bear market, for example, at either the very end of the bear market or during a simple temporary reversal before the bear finally yields to the bull, you are literally doubling your losses. How? When you short a stock, you are actually borrowing shares of that stock and then selling them in the open market, without ever actually owning the shares. Then, you must buy back those same shares at a later date to return to the owner.
The goal as a short seller is to purchase the shares back for less cost in the future and net a profit when the stock drops. However, if you are shorting during a bear trap, the shares’ value increases, and you run the risk of suffering major losses that can continue to snowball into unlimited losses.
How to Avoid the Trap
One way to avoid the trap is to simply avoid selling short. Short selling is risky, especially during bear traps, because your losses can continue indefinitely. One of the ways to avoid losing unlimited capital when shorting, though, is through a stop-loss order. While you will still lose money, a stop-loss order will “stop the bleeding” and cap your losses. A stop-loss order is designed to limit an investor’s loss on a position and is placed with a broker to buy or sell an asset once it reaches a certain price.
Utilizing all of the aforementioned technical indicators and behavioral finance concepts can go a long way in avoiding bear traps. It is really quite simple. If you understand your technical indicators, you can foresee them coming. If you understand behavioral finance, you will remain disciplined, principled, and stable as an investor. While these traps are extremely commonplace and can happen to anyone, just stick your indicators and principles, and everything should work out simply fine.