EXPLAINER: Bear Traps and How to Avoid Them

The bear trap is one of many pitfalls to be cautious of in the investment world, especially cryptocurrency. The bearish investor or trader expects a break downward through a resistance level to be followed by further downward movement. Thus, they are 'trapped' and lose money after the reversal in price back upward.

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A bear trap is a fake pattern that indicates a reverse of an escalating price trend in an asset, index, or other investment instruments.

This is why it is referred to as a ‘trap.’

When an asset’s value drops suddenly, investors may be motivated to sell their holdings to protect themselves from further losses if the downward trend continues.

A bear is an investor or trader in the financial markets who believes that the price of a security is about to decline. Bears may also believe that the overall direction of a financial market may be in decline.

However, the price trend shifts as investors sell their assets. As a result, investors miss out on potential gains that might have been much greater.

Causes of a Bear Trap

What causes a bear trap is not just the downward price movement, but a drop in price below a key support level.

The bearish investor or trader expects a break downward through a resistance level to be followed by further downward movement. Thus, they are ‘trapped’ and lose money after the reversal in price back upward.

In certain markets, there may be a large number of investors interested in purchasing a stock but the sellers are unlikely to accept their offer. To make purchases, a buyer would often raise their offer price. 

This sort of bid happens with the imbalance between selling and buying demands. It will naturally attract more sellers to the market and lead to price growth.

Investors can only earn a profit when they sell their shares. Thus there will be selling pressure as soon as the shares are effectively bought. Because of this, if too many individuals buy stock, the buying pressure will be reduced, leading to an increase in selling pressure.

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SEE ALSO: Investment Opportunities, Risk Management, and Market Liquidity – Which Crypto Exchange Can You Trust?

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To make the market appear more bearish, some traders would lower the stock price, and inexperienced investors may then sell their stock. Investors return to the market after the stock price drops, and the stock price rises due to increased demand.

In order to protect profits, a bullish trader can sell a declining asset, whereas a bearish trader would sell the asset to repurchase it once the price has fallen.  As a result, a bear trap occurs when the downward trend continues for an extended time before turning back up.

In summary, the causes of a bear trap are:

  • Drop in price below a key support level
  • Investor or trader enters into a short position
  • Drop below the support level is brief and followed by a reversal upward in price

Ways to Avoid a Bear Trap

The bear trap is one of many pitfalls to be cautious of in the investment world, especially cryptocurrency. 

Any downtrend must be driven by high trading volumes to rule out the chances of a bear trap being set up. Generally speaking, a combination of factors, including:

  • The retracement of price just below a key support level
  • Failure to close below critical Fibonacci levels, and
  • Low volumes

are signs of a bear trap being formed.

The only reliable way a trader can avoid a bear trap is to avoid entering into a short position altogether. But there are alternatives to short selling, such as options, or ways to avoid certain situations, such as low trading volume, when bear traps are more likely to occur.

For crypto investors with a low-risk appetite, it is best to avoid trading during abrupt and unsubstantiated price reversals unless price and volume action confirms a trend reversal below an important support level. 

Ways to avoid a bear trap are:

  • Avoid short positions when trading volume is low for the investment security – Bear trap risk can increase when volume is low
  • Use alternative trading strategies that can limit losses, such as buying put options – In theory, there is no limit to losses with short selling
  • Advanced traders may use Fibonacci levels, which involves a technical analysis method that can help a trader determine support and resistance levels
  • Avoid entering into a short position altogether

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.

A bear trap pattern involves technical trading and is not a suitable strategy for long-term investors.

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RECOMMENDED READING: Why Did Crypto Markets Plummet on Saturday, December 4, 2021?

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