Bear traps in trading are just as unpleasant to be caught in as the ones in real life — although they are a lot less likely to cost you one of your limbs. They can, however, bleed your funds dry.
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What Is a Bear Trap?
A bear trap in trading is a false technical pattern that can be observed when the price of an asset on the crypto or stock market incorrectly shows a reversal of an upward trend to a downward trend. Bear traps are similar to short squeezes, but the price rallies they cause are often smaller and take longer to begin.
To put it simply, a bear trap is a fake price drop, often orchestrated by a few or more traders to trick other market participants, mainly novice investors, into selling a particular asset. It is called this way because it traps bears — traders who are looking to benefit from a price drop/downward trend.
How Does Bear Trap Trading Work?
Bear traps falsely signal a bearish trend, tricking some traders into thinking that there might be a prolonged price decline coming. While they may occur naturally, more often than not, bear traps happen on the market due to coordinated actions of institutional investors or other big players, like crypto whales.
An orchestrated bear trap occurs when there are a lot of institutional and/or experienced traders on the market who want the price of an asset to rise. To do that, they sell a large amount of the said asset, aiming to increase the buying pressure and decrease the potential selling pressure. This pushes the prices to decline, which can scare novice traders off. So, they could end up selling their stocks, fiat, or crypto to minimize losses out of fear of further price drops.
However, as the buying pressure increases, there will be a lot of traders looking to buy in, which will create a sudden price reversal. Additionally, the same novice traders will now be compelled to buy back the stock they have just sold out of FOMO. As the involved asset starts to see more demand, the prices will rise, allowing experienced traders to reap profits.
Some seasoned traders can get caught in bear traps, too, although in a different manner. This kind of trap is particularly dangerous and devastating for unaware, inattentive, or simply non-institutional short-sellers, who may see the downward trend as an opportunity to open short positions only to receive a margin call when the prices go up. Typically, only the short-sellers who know the bear trap is about to occur or discover it just as it begins and trade accordingly can profit from it.
Crypto markets are notoriously easy to manipulate. Many traders involved in cryptocurrency trading are novices — after all, crypto has a much lower entry barrier and higher potential profits than stocks or Forex. Additionally, the lack of regulation in the crypto industry also contributes to bear (and bull) traps being quite easy to execute as whales can communicate and organize bear traps without fear of repercussions.
How to Identify a Bear Trap
The only reliable way to identify a bear trap is to use technical analysis. Experienced traders can make use of the RSI indicator and Fibonacci retracements in order to check whether the price drop is questionable and is likely to continue or not.
However, technical analysis is not for everyone, and while it’s the best way of identifying bear traps, it’s not the only one. For example, even though price volumes are a technical indicator, they are easy to understand and displayed clearly in pretty much all trading terminals. If the trading volumes for the current price drop are lower than usual when the price is in decline, then there could be a bear trap.
Checking out public opinion and news is another good way of identifying a bear trap. If nothing has happened that could cause the value of an asset to decline (bad news, negative opinions from popular influencers, etc.), and the community seems to have a rather positive attitude, then it could be a bear trap.
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Bear Trap Example
A typical bear trap works like this: imagine we’re in the middle of a bull market, and you’re one of the inexperienced traders looking to cash in on your investment. The crypto/stock prices that you’re following only keep on rising, so you haven’t sold any of your assets yet in the hope of getting a bigger profit. Then, suddenly, there’s a trend reversal, and prices start going down. What would you do in a situation like this?
Well, as it happens, many traders rush to sell their assets in fear of a total crash. However, as the prices drop, other traders, especially experienced ones who understand that the market is fine and the asset still has room to grow, decide to buy the asset, which drives its value up. The “weak hands” that sold their assets earlier decide to buy back in. This often leads them to be stuck in losing trades.
Bear Trap vs. Bull Trap
Just like a bear trap, a bull trap is also a false trading signal, but in reverse: it tricks people into thinking that a bullish trend is about to come, causing them to open long positions and buy assets. However, as it is a trap, after the short spike, the prices continue declining, leaving many market participants caught in a bad trade.
How to Avoid Bear Traps
As we have already mentioned, bear traps are easy to execute in the crypto market, so it is crucial to learn how to avoid getting caught in them.
- Avoid opening short positions, especially if you are not that experienced.
- If you do open a short position, make sure you understand the risk and use a stop-loss order if possible.
- Don’t trade shitcoins and other cryptocurrencies that don’t have that many active traders: those assets are illiquid and, thus, extra vulnerable to bear traps.
- Do as much research as possible and practice trading with smaller sums. As you become more familiar with the market and gain experience as a trader, you will get better at identifying bear traps. Good luck!
Disclaimer: Please note that the contents of this article are not financial or investing advice. The information provided in this article is the author’s opinion only and should not be considered as offering trading or investing recommendations. We do not make any warranties about the completeness, reliability and accuracy of this information. The cryptocurrency market suffers from high volatility and occasional arbitrary movements. Any investor, trader, or regular crypto users should research multiple viewpoints and be familiar with all local regulations before committing to an investment.