Bear Trap in Trading: Explained for Beginners
A bear trap is a household name for a particular trading pattern in the stock market. Essentially, it is a relatively sudden movement in a stock or the market in general that attracts investors who attempt to bet on future losses. However, in a true bearish trap, the market quickly reverses the other way, “trapping” those negative-minded investors. But how did a bear trap get its colorful description and what does it really mean for the average investor? Here is an exploration of all the ins and outs of what a bear trap really is in trading.
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What are bulls and bears?
In order to understand what a bear trap is, it helps to first understand the Wall Street terms “bullish” and “bear”. Generally speaking, a bullish investor is one who believes that the market – or an individual stock – will rise in price. A bearish investor is the opposite, betting on falling prices. The terms are said to derive from the attacking stances of the respective animals, with bulls rising up and bears down. However, the real reason for the names is lost to history.
The terms bullish and bearish also apply to general market movements. For example, a market that has fallen 20% or more is often referred to as a bear market, while a reversal to new highs triggers a new bull market.
Bearish investors try to take advantage of market downturns in several ways. Some simply sell their stocks and sit on the sidelines as they watch the market fall, while others are more proactive and actually looking to profit from a sell-off. One way to do this is to sell shares “short,” which is a trading strategy that requires an investor to borrow shares of a company and sell them in the open market. The idea is that if prices continue to fall, the short investor can buy back those shares at a lower price in the future. A profit is realized if the redemption price is lower than the price at which the shares were originally sold short.
Why is it called a bear trap?
A bear trap is a trading pattern in which the price of an individual stock or the market as a whole falls sharply, only to reverse shortly thereafter. At the time of the initial decline, bearish investors may need to short stocks, attempting to capitalize on the price drop. But when prices reverse sharply afterwards, these bears get “trapped” in their short position, losing money every day prices continue to rise.
The idea behind calling this type of trading pattern a bear trap is that bearish investors sit and wait for prices to drop so they can jump in and take advantage of short positions, but instead they get trapped. when prices reverse course and move higher. These bearish investors are now trapped in their losing positions.
What does the technical business model of a bear trap really look like?
Bear traps are identified by market technicians, who use past stock and market price movements to guide their trades. Although the patterns and technical terms can be a bit overwhelming for the newbie investor, it is good to have a basic understanding of them.
A “support level” in a stock or index occurs at a level at which investors have previously bought stocks. Typically, stocks tend to bounce higher from these levels as investors are drawn back into the market and thus provide support for stocks.
When markets break through so-called “support” levels, technicians suggest further selling is ahead. While this can often be the case, sometimes a breakout, below the support levels, reverses soon after. This is the technical definition of a bear trap. Investors expect the breakout to be the precursor to further selling, but they find themselves trapped when prices begin to rise again instead of continuing to fall.
How do bear traps affect average investors?
Bear traps have no real effect on the typical long-term buy-and-hold investor. To begin with, the average investor has a bullish bias, hoping and even expecting the stock market to rise over time. Betting against the market by taking a short position is usually not part of the average investor’s arsenal. In fact, for bullish investors, bear traps actually represent an opportunity. When prices fall, long-term investors can usually profit by buying additional stocks at lower prices. If the market returns to new all-time highs after the sell-off – which has always happened, historically speaking – these bullish investors ultimately profit from rising prices.
Of course, just as there are bear traps in the market, there are also bull traps, and these may be more likely to trip up the typical investor. Acting the opposite of a bear trap, a bull trap trading pattern is represented by a sharp rise in prices that attracts bullish investors, only for those prices to quickly turn around and fall. Investors who have crowded into the market hoping to follow the upward price trend are then faced with the prospect of immediately losing money on their positions.
Bear traps are something of a stock market “head hoax,” luring bearish investors in, then cutting them off as prices resume their ascent. The good news is that for the average investor, bear traps are a non-event, and maybe even an investment opportunity. But if you are a bearish investor by nature, a bear trap represents a dangerous trading pattern that could cost you money. It is best to be fully aware of how bear traps work before entering the world of stock shorting and attempting to take advantage of price declines.
Information is accurate as of September 19, 2022.