In the stock market, traders need to look at the bear trap and how it works, especially for beginners.
Bear traps often occur in strongly trending stocks which results in a false trend reversal when the price is in an uptrend.
The stock market is very volatile, and over the years trading has improved and expanded, now, it’s not just buying, selling, or exchanging, traders must develop tactical skills in other to predict the stock market movement.
In this post, we will be talking about how bear traps work and what they mean to investors.
What Is A Bear Trap?
A bear trap is essentially when a stock market price begins to break down below the support level, only to have the stock reverse and shoot higher. This reversal move produces a trap and often leads to speed rallies.
These bear traps can often trick investors short because of a false movement, getting them caught in a trap, it runs up and the market continues to climb higher
Why Is It Called a Bear Trap?
In the stock market, we have what is called the bull and bear trap, these two terms are used to describe two opposite market scenarios when a market is rising and falling. When the market is rising with predominant buying forces, it is called a bullish trend. And when the market is falling it refers to an as bearish condition, when the market is falling, mainly due to a selling spree.
Bear Trap vs. Bull Trap
- Bear Trap: After an upward trend in price, a sudden break down in price below a key support level sends a false bearish signal, luring bearish traders to sell short, only to be followed by a reversal upward in price.
- Bull Trap: After a downward trend in price, a sudden break upward in the price above a key resistance level sends a false bullish signal, luring bullish traders to enter long positions, only to be followed by a reversal downward in price.
How Does a Bear Trap Work?
Bear traps tempt traders into entering short positions based on the expectation that price will continue to fall which never happens.
Usually, traders set bear traps where they sell assets until other traders are convinced that the upward trend has ended and the prices will drop. As the prices continue to drop, traders will be fooled thinking its upward trend has stopped or is dropping.
What Does a Bear Trap Look Like?
Why Do Bear Traps Happen?
- An existing bull trend in the market or overall bullish sentiment
- Sharp reversal due to the profit-booking by institutional investors
- This sharp reversal might be seen as a sign of trend reversal by bearish traders who are looking for a top formation
- these traders might want to short the market, either because they feel that the market is overvalued, or because they feel that a correction of the trend is imminent
- the bearish traders often mistake this reversal and enter the market hoping to ride the wave of liquidation by small traders.
How to Identify a Bear Trap
It is important for every trader to be able to identify a bear trap when they see one in order to minimize the risk of losing all their funds.
- Market Volume: The market volume is a critical indicator of a bear trap. There is a significant change in the market volume when a price is potentially rising or dropping. However, if there is no significant increase in volume when a price drops, it is most likely a trap.
- Divergence: Certain indicators provide divergence signals. When there’s divergence, there is a bear trap. To look out for divergence, you have to check if the indicator and the price in the market are moving in different or opposite directions. Using this to determine whether a bear trap will occur, when the price and indicator are moving in the same direction.
How To Avoid a Bear Trap
The best way to avoid a bear trap is to use technical analysis, if you see the volume decreasing significantly, this might be a bear trap. To avoid being caught, follow these simple guidelines:
- Always ensure you set a stop loss: Setting a large stop loss will help you minimize the risk
- Follow large trends: If the support level is not in the direction of a larger trend, be careful because there’s a high probability for a bear trap to happen because traders will be getting in after the candlestick to push up the price.
- Ensure you trade the retracement and not the breakout
- Don’t Short Into Upside Momentum: Most stocks remain in a period of range contraction–not doing a whole lot–most of the time. Bear traps are events on the range expansion spectrum’s far-end, however, and occur at the least expected times.
A bear trap can be caused by a decline in an investment security’s price, triggering some bearish investors to open short sales, which then lose value when the price action reverses course and rises again. This can’t be 100% avoided and is not a suitable strategy for long-term investors.
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