By Larry Wright
Trading today involves a far larger variety of activities than merely the purchasing, selling, or trading of products or services. Despite the fact that trading is a highly fruitful venture, there is a widespread perception that trading is a very challenging and risky activity, especially for those who have difficulty acquiring a comprehensive grasp of investment techniques. It is true that a financial market is a place that is riddled with a great degree of uncertainty since investors have no clue what direction the market will go in the next minute, and therefore, there are always significant risks associated with one’s trading endeavor.
A number of studies have been carried out, and various tools, such as the trading simulation environment, have been created specifically for the purpose of assisting traders in making more informed decisions on their investments in trading.
However, despite the fact that there are instruments accessible to aid investors, there are also traps that they must avoid at all costs since the financial losses that are linked with such occurrences may be enormous. The bear trap is a good illustration of such a pitfall. Bear traps are among the numerous possible risks that investors in the financial sector, especially those dealing in cryptocurrencies, need to keep an eye out for. Have you heard of anything called a bear trap before? Do you understand how it works?
It is crucial for all levels of traders who want to have a productive investment portfolio that they understand the nature of bear traps, as well as their actions, results, and tactics for mitigating the risks associated with them. In the following guide, we are going to discover all there is to know about bear traps, beginning with its description and progressing all the way up to the best approach to prevent any issues. Just keep reading!
What is a Bear Trap?
A misleading technical indicator of a turnaround from a down-market to an up-market is called as a bear trap. These kinds of events are possible in any and all marketplaces for assets, such as those for shares, commodities, securities, and cryptocurrencies. In other words, a bear trap is a false signal that predicts a reversal of an escalating price movement in a digital asset and this is why people frequently allude to it as a “trap.”
Whenever the valuation of a product experiences a precipitous collapse, owners may feel compelled to liquidate their investments in order to safeguard themselves from incurring more damages in the event that the steady decline persists.
Bull and bear are twin phrases that are employed in the marketplace to express two different economic attitudes that are completely contradictory to one another. A bullish trend occurs when purchasing forces are more prominent than selling factors, and the marketplace is increasing as a result. A bearish situation is the reverse of a bullish circumstance and occurs whenever the marketplace is dropping, most often as a result of a selling frenzy.
Although most investors will tilt in one direction or another, you may still find some that participate in trading whether the marketplace is bullish or bearish. An investor who is bearish will keep an eye out for market prices that are suggestive of a declining trajectory. This will allow them to short sell and get out of the transaction with a reward.
The circumstance known as a bear trap is one that occurs during an upswing and causes it to cease suddenly. Short selling might be an option for a pessimistic investor who views the current scenario as perhaps signalling the start of a downward trend. It happens when investors short a falling stock with the expectation of buying it back at a lower price, only to see the stock suddenly spike upwards. The result is a trap, which is then accompanied by a strong rebound.
Locating a bear trap on the diagram showing trends is a rather straightforward process. It takes place in the vicinity of the support line. There is a significant decline, which is complemented by a significant increase in shares traded. Confirmation of a trap occurs when the pattern continues inside five candlesticks and forms a line above the support zone, following the movement quickly breaking through the breakpoint. The stock should also be in an acceptable price range, which is something else you should verify. When there is a large price fluctuation for an investment, there are more options for trading.
Let’s try comprehending the idea of a bear trap with the help of an example.
A bear trap is created whenever a stock or other investment that has been steadily declining in currency abruptly starts to rise in price conversely, as we just learned. The same thing may happen if a stock that is anticipated to tumble down keeps trending higher. Bearish speculators who have crimped the stock or placed bets upon it may suffer revenue damage as a result of such an unanticipated trend. A customer with such a short position may get a margin call from their brokerage if the valuation of the asset they are shorting rises over their initial investment.
Let’s say that trader shorted $100 worth of ABC securities, but the stock is now falling. ABC has dropped to $85 since you opened this trade; consequently, you anticipate that you will be able to generate a benefit if you decide to terminate it. But before you’re able to buy enough shares necessary to do so, ABC begins to soar and hits $110 per unit. If you terminate the investment at this time, you will guarantee yourself a loss of ten dollars for each share. Your brokerage may demand that you unwind the arrangement or submit additional cash if the number of securities you shorted is too high in proportion to the capital in your portfolio.
The bear trap effectively compelled you to either liquidate your investment or make an additional cash payment in order to prevent a margin call. This is the case regardless of whether the increase in value is just a temporary surge, and ABC subsequently starts its steady decline. If, indeed, the stock remains to go higher, your liabilities will keep piling up until you either cut your deficits or exit the strategy.
How Does Bear Trap Work?
A bear trap is a situation in which investors are led to believe that a downturn is occurring, along with a reduction in the value of the capital asset. If, on the other hand, the cost of the item does not change or, even worse, if it increases, traders will be obliged to bear a loss on the transaction. A dealer who is bullish would consider short selling if the market of an asset is falling, whereas a trader who is bearish would be short in order to purchase the very same commodity again whenever the market decreases to a particular stage. On the other hand, if you walk into a bear trap, this tendency will reverse in the other way.
When shorting or engaging in speculative trading, which includes short selling, traders often make use of a bear trap. To create a gain from a transaction, the practice of shorting entails selling an item when its price has gone up and then purchasing this very same commodity when its market is decreasing. Bear trap investing enables participants to take short positions via a variety of means, including borrowing shares from their brokers using margins.
Whenever you anticipate that the marketplace will go down, you will sell your shares at the present price in order to purchase them at a reduced cost and then transfer them to the brokerage, keeping the profit (price difference between the two) as your profit. However, your danger multiplies exponentially if you engage in shorting activity while in a bear trap. If the price goes up rather than down, you will wind up paying a higher total cost for the shares if you repurchase them whilst trying to keep your margin the same. Therefore, whenever a bear trap happens, the risk that a bear buyer embarks on is significantly greater than the danger that bullish speculators take on.
A number of technical trading techniques, including Fibonacci retracements, momentum measures, relative strength oscillator and others, are employed by traders to distinguish between a bear trap and a true market turnaround. If a powerful bullish tendency is abruptly broken by a worrisome downturn, you should analyse other marketplace factors to determine why the event occurred rather than leaping to the conclusion that the declining trend is to blame.
A bear trap is most likely present when there is no discernible shift in the general attitude of the marketplace that may lead to a price turnaround. As a matter of fact, the liquidity of the market is an essential signal that may assist you in recognising potential bear traps in ahead. Whenever a market capitalisation is getting closer to a new peak or trough, the trading volume varies considerably, which is an indication of a shifting trend. However, when there is a decrease in pricing but not a correspondingly increase in trade volumes, then it is most likely a trap.
The Fibonacci bands represent yet another important technique that might provide advanced notice so investors can be aware of the impending bear trap. If the market capitalisation does not reach key Fibonacci lines, then perhaps the movement turnaround will most likely be a temporary one. If you suddenly find yourself in a downward trend and are unsure what it signifies, you should check the indications. Strong indications may be generated by gauges, and a discrepancy is straightforwardly observed on the trend chart.
After one bear trap has been sprung, the stock market will often see a brief but significant upswing, which is mostly driven by short-term speculators looking to profit from the dropping marketplace. Whenever the bulk of investors see that the upswing is sustained rather than the market dropping again, this ushers in the second wave. The new movement is often more powerful compared to the initial bounce, and it finally breaks through the peak of the short-term range.
Bear Traps and Short Selling: How Are They Linked?
Bearish traders are participants in the capital exchanges who acquire or trade with the expectation that the value of specific securities will go down in the near future. Bears are also prone to the belief that an overarching downward trend may be developing in a particular economic sector. A bearish investing approach seeks to generate profits from a decrease in the value of a commodity, and the application of this method frequently involves short-selling the resource in question.
To take a short position in the market, traders borrow stocks or futures of a commodity from their brokerage using their margin account. A trader may benefit from a decrease in the cost of loaned securities by selling them and then repurchasing them at a discounted cost. The likelihood of a bearish trader falling victim to a bear trap grows whenever the customer fails to accurately identify the beginning of a market decrease.
When prices go up, short sellers have little choice except to cover their bets in order to prevent further damages. Subsequently, elevated purchasing interest has the potential to kick off more price gains, adding fire to the cost increase’s drive. Nevertheless, the rising velocity of an asset often decreases when short sellers buy the securities necessary to offset their short holdings.
How to Avoid Bear Traps?
Bear trap trading is often used by traders for the purpose of engaging in short-selling or shorting. Despite this, it is quite evident that bear traps remain dangerous and need to be shunned wherever possible. You won’t be able to make up the money you lose. In order to prevent being trapped in a bear trap while trading, it is vital that you have a solid understanding of what bear traps constitute and what characteristics show the presence of a bear trap.
When you are trading, use patience and don’t let the recent dip in prices influence your decision-making power. When you are trapped in a bear trap, users run the risk of losing their money very rapidly. The following seem to be some precautions you may take to prevent being trapped in a bear trap:
Make use of other candlestick patterns, such as the reverse candlestick. It is a very reliable signal that will assist you in staying clear of any bear traps. This configuration usually forms in the marketplace immediately after a decline, signalling that the current low prices are likely to be temporary.
Bear traps are more likely to appear during a downward trend. Thus, it is important to monitor the duration of a downward trend. Keep an eye on how long the pattern has already been continuing, and in the event of a protracted slump, you should avoid joining the marketplace at all costs.
Increase the size of your stop-loss orders and make sure they are not placed below resistance and support lines; please be very aware of this. These would serve as a safe buffer zone that may serve as a resting place for the market in the event that erroneous breaches or market decreases take place.
Pay attention to the amounts. The volumes are a good indicator of a bear’s strengthening. If a volume signal does not display manifestations of a rise in volume, then there is a small likelihood that the bears will be able to drive the market down anymore. It is strongly recommended that one does not join the marketplace at this moment.
Bottom Line
We all fall prey to some frauds and traps at some point or the other. It’s possible that we’ll fool ourselves into thinking that we’ve discovered something that the broader market is overlooking just to have the marketplace debunk our assumptions. This is a circumstance that may happen to anybody at any moment, and there is no need to be embarrassed about it. The distinction is in how we respond when we find ourselves caught in a chaotic exchange, and that’s exactly why this guide was written- to help you avoid such dangerous pitfalls.
You won’t be able to evade a bear trap if it happens to you. Whenever the cost of a financial instrument drops, bearish individuals may be enticed to establish short positions, which subsequently become worthless whenever the valuation of the asset increases. Because it includes technical investing, a bear trap design is not an investment technique that is appropriate for long-term consumers. If you lack prior knowledge of the financial markets, you might find it even harder to deal with these traps.
However, with enough expertise and the assistance of several economic indicators, traders like yourself can smartly identify a bear trap and could even discriminate between a genuine market drop or a trap sent to lure poor traders.