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What is a Bear Trap?
What’s important to know about it?
In this article, I will break down the meaning of Bear Trap so you know all there is to know about it!
Keep reading as we have gathered exactly the information that you need!
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Table of Contents
What Is Bear Trap
In investing, a bear trap is a term used by traders to refer to a downward movement of a stock or security leading investors to believe that an upward trend is shifting to a downward trend.
In other words, a bear trap is when a security shows signs that it is going to decline in value leading investors to take short positions or sell their shares.
For example, an institutional investor who has a significant long position in a particular stock may sell some shares leading retail investors into a bear trap where the price of the stock temporarily goes down.
When the stock price eventually goes back up, the retail investor will be forced to close out its short position to avoid further losses causing a further rally in the stock price.
In this example, you can see that the retail investor took a short position thinking that the stock price will continue declining but fell into a bear trap.
A bear trap is a term that can be used when dealing with any type of asset or security, such as stocks, bonds, currency, cryptocurrency, ETFs, or any other traded instrument.
Keep reading as I will further break down the meaning of the bear trap in investing and tell you how it works.
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How Does A Bear Trap Work
A bear trap is a technique used by some traders to earn a profit on a stock.
The investor who is looking to profit from a bear trap will want to take a long position in a stock, push the price of the stock down by creating a temporary selling pressure, buying the stock when the price drops, then finally earn a profit when the price goes back up.
Here is how bear trap trading works step by step:
Step 1: An institutional trader will want to push the price of a stock down by selling shares.
Step 2: Retail investors notice that the stock is going down so they may choose to sell their long position to cash out their profits, pushing stock prices to go down further.
Other investors may bet that the stock price will drop further and short the stock hoping to make some profits.
Step 3: When the stock price goes down, the institutional investor will buy back shares at a lower price driving the price back up.
Short-sellers will be forced to close out their short position by buying the shares to mitigate their losses.
Step 4: When the stock price goes up, the institutional investor earns a profit has created a false impression of a bearish trend in the stock price.
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How To Avoid Bear Traps
The main strategy an investor can adopt to avoid a bear trap is to avoid taking a short position on a stock having an upward price movement.
Typically, if the trading volume on a stock is low when there is a sudden break in the upward price movement, you will be more exposed to a bear trap.
In this situation, you should avoid short-selling the stock.
You can also avoid a bear trap by trading derivatives like put options.
If you think the price is going down, you can purchase put options allowing you to bet on the downward price movement and have a limited loss.
In theory, short-selling can expose you to greater losses the more the stock price goes up.
Technical traders may consider using techniques such as Volume indicators, Fibonacci Levels, Divergence, Price Action, and other techniques to avoid falling into a bear trap.
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Bear Trap vs Bull Trap
What is the difference between a bear trap and a bull trap?
A bear trap is when an upward trend suddenly breaks and the stock goes down in value causing bullish investors to sell their shares and bearing traders to take short positions.
However, this shift in price movement is only a bear trap as the price movement reverses again and goes back up.
Those who bought the shares at a lower price will make a profit when the price goes back up.
A bull trap is exactly the opposite of a bear trap.
A bull trap is when a downward trend of a stock is suddenly broken with an upward trend in the stock price leading bullish investors to buy shares and bearing investors to close out their short positions.
Then, the price movement shifts again and the stock continues to decline further in value.
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Bear Trap vs Short Sale
What is the difference between a bear trap and a short sale?
A bear trap is when investors or traders falsely believe that a stock’s upward price movement has reversed, leading them to close out their long positions or short-sell the stock.
Investors who sell the stock are those looking to cash out their profits falsely thinking the stock is doing to continue going down in price and those short-selling are those who are hoping to make a profit by betting the stock will continue to go down in price.
However, the downward movement is short-lived and reverses back to an upward trend forcing short-sellers to close out their positions and allowing investors who bought at lower prices to earn a profit.
A short sale is a trading technique where an investor borrows shares from a brokerage firm and sells them using his or her margin account.
If the stock price goes down, the short-seller earns a profit by buying back the borrowed shares at a lower price and pocketing the difference.
However, if the stock price goes up, the short-seller will lose as he or she will need to buy back the shares at a higher price than what it was initially sold for.
When short-sellers hold on to stocks that are going up in value, they will get a call where the brokerage firm will ask them to cover the value of the potential loss.
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So there you have it folks!
What does a bear trap mean in trading?
In a nutshell, a bear trap refers to a technique used to cause bearish investors to lose money by creating a false impression that the stock price is going down leading them to sell their shares.
A bear trap happens when there’s a sudden downward price movement on a stock or asset leading bearish investors to sell.
With an increase in selling pressure, stock prices go down allowing sophisticated investors to take a long position in the stock at a lower price.
However, since the downward price movement is only temporary, the stock price goes back up, the unsuspecting investors who sold may have lost some money, and the sophisticated investor will have gained by buying the stock at a lower price.
Investors should make sure they properly study the market before investing and seek advice from a professional to ensure they do not make costly mistakes.
Now that you know what is a “bear trap” in trading, good luck with your research!
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