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 forces 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.

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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 in price.

This prompts bearish traders to open short positions, hoping to profit from a further decline in the price. However, if the decline proves to be temporary, the price starts to move higher once again. The traders have been trapped and need 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. 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 those key technical resistance levels. Shorts are forced to cover, and the asset can increase in price – sometimes very rapidly – causing considerable losses to those traders caught in the bear trap.¹

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 are difficult to identify. It's really only after the short squeeze rises and the trade has gone wrong that the bear trap becomes evident.

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 trend lines, Fibonacci levels, resistance levels, candlesticks, short-term moving averages, MACDs, Bollinger Bands and volume.

You should monitor the open short interest in a stock to see how crowded the short actually is. You can monitor short positions for UK-listed companies and US-listed companies. 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.

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

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.

How to trade a bear trap

1. Do your research about the different markets
2. Open an account or practise with a free demo account
3. Decide whether you prefer to trade using spread betting or CFDs
4. Select your opportunity: you can trade shares, stock indices, foreign exchanges or commodities
5. Open the position and manage your risk

With us, you’ll trade using spread bets or 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.

Both spread betting and CFD trading are leveraged, so you could gain or lose money quickly – including the potential to lose more than the initial deposit paid to open the position. That's because 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 spread betting and CFDs, your currency exposure and initial margin will vary according to which asset you choose to trade. To manage risk, many traders set stop losses to try prevent outsized losses.

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

• Bear traps are hard to identify until they have actually happened
• You should use fundamental and technical analysis to identify and trade bear traps
• You can trade bear traps from both the long side and short side
• Risk management, including the use of stop losses, is important when trading bear traps due to increased volatility

Sources

1. Call Option Payoff – Steady Options