What is a bear trap and how does it work?

What is a bear trap in trading?

A bear trap is a reversal against a bearish move that may force traders to abandon their short positions in the face of rising losses. It's called a trap because it often catches traders off-guard, and it comes on the back of a decline in the market that looks likely to continue.

Learn more about fake-outs and break-outs.

How does a bear trap work?

A bear trap can occur in stocks, indices, commodities, currencies or any other financial instrument.

After a strong upward rally, the price of the asset looks to have encountered strong resistance and starts to decline. This prompts bearish traders to open short positions, hoping to profit from a further decline.

However, if the decline proves to be temporary, the price starts to move higher once again. The traders have been trapped and typically look to cover their short positions.

Bear traps often occur after the security has had an extended move higher and the price appears to have failed to move above a key technical resistance level. The asset likely looks overvalued when considering fundamental analysis.

The opposite of a bear trap is a bull trap. This is where traders buy an asset, believing the downtrend is over because the asset has started to rally. But the downtrend resumes soon after, leaving holders of the asset 'long and wrong' as the price declines once again.

How to identify a bear trap

Bear traps can be difficult to identify. It's typically only after the short squeeze, and the trade has gone wrong, that the bear trap becomes evident.

Bear traps can be short-lived, but they're normally characterised by a sharp move higher on increased volumes. If a security's price moves with increased volume, that gives the move more credibility.

However, you should always do your research and plan ahead of trading. Do this by carrying out both fundamental analysis and technical analysis to understand the key drivers of an asset.

The fundamentals of a company are unlikely to change materially in the space of a few days. However, the technical picture can change rapidly. This will likely be your primary focus when identifying a bear trap.

Technical analysis has a huge array of indicators that can be used to identify important resistance and support levels. These indicators include the Fibonacci retracement tool, moving average (MA), moving average convergence/divergence (MACD), and Bollinger Bands.

Bear trap example

Bed Bath & Beyond is a company that has seen several bear traps. In 2022, Bed Bath & Beyond's fundamentals were weak, with around $3 billion of debt and little cash on its balance sheet. With its business struggling, and investors questioning whether the company could continue, traders identifed an opportunity for short selling.

There have been several sharp rallies that could be considered bear traps for Bed Bath & Beyond company shares. The largest was in the middle of 2022. In June and July of that year, the stock was drifting lower.

But in August, the share price started to rally – slowly at first, and then more rapidly. It went from around $5 to $23.

In this example, the volume and share price both accelerated. These increases could have been considered a warning that a bear trap was forming. The share price eventually underwent a sharp reversal, falling to $1.66 in January 2023.

But for those who were short, that sell-off was too late. Many were forced to cover, as the share price rallied strongly and the losses became too big to handle. They had been caught in the bear trap.

Despite the fundamentals of the company remaining weak, the share price still managed a strong rally on more than one occasion. Technical analysis may help to identify bear traps such as this one.

How to escape a bear trap

You could avoid a bear trap using a stop loss to help manage your risk. There are several types of stop orders, including standard, trailing or guaranteed.

To avoid a bear trap, a trailing stop would probably help you the most because it tracks the current market value by a set amount of points, and it will automatically close your position if the market value rallies by that set amount.

This will help you to lock in as much profit as possible, while also cutting losses early on into a bear trap.

Learn how to manage your risk.

Risks of bear traps in trading

When the asset starts to decline in price, traders believe this decline is going to continue and decide to sell (or go short) the asset. However, the downward direction turns out to be temporary, and the price starts to move higher again, often breaking above key technical resistance levels. Traders with short positions are thus forced to cover, as the asset can keep increasing in price – sometimes very rapidly – which can cause considerable losses to traders caught in the bear trap.¹

You can monitor the open short interest in a stock to see how crowded the short is. 2,3 The larger the short position as a percentage of free float or average daily volume, the more potential risk there is of a bear trap forming, as more traders may be forced to cover their shorts.

How to trade a bear trap

1. Create an account or log in
2. Learn more about bear traps
3. Open your CFD account and search for your bear trap opportunity
4. Select 'buy' to go long or 'sell' to go short
5. Set your position size and take steps to manage your risk
6. Open and monitor your position

With us, you’ll trade using contracts for difference (CFDs). You take a position on price movements – whether you think it’ll go up or down – rather than owning the underlying asset outright.

CFD trading is leveraged, so you could gain or lose money quickly – including the potential to lose more than the initial deposit paid to open the position as potential profits and losses are magnified to the full value of the trade. It's useful to keep in mind that past performance isn't a guarantee of future patterns.

With CFDs, your currency exposure and initial margin will vary according to which asset you choose to trade. To manage risk when trading CFDs, many traders set stop loss orders to try prevent outsized losses.

New to investing or trading? Practise on a demo account to build your confidence.

Possible opportunities during bear traps

After identifying that a bear trap is in effect, you can wait to see if the price starts topping out after the sharp move higher. Then, you can open a short position. You could also open a long position – either during the downtrend or after the initial move higher – above a key technical level to potentially profit from the future upward trend.

Bear trap trading summed up

• You can use fundamental and technical analysis to identify and trade bear traps
• You can trade bear traps from both the long side and the short side
• Taking risk management measures, such as setting stop losses, is important when trading bear traps due to increased volatility

Sources

1 Steady Options, 2023
2 Castellain Capital, 2023
3 High Sort Interest, 2023