By: Ganesh Adhikari
“Be fearful when others are greedy, and greedy when others are fearful” – Warren Buffett
Have you ever sold the stocks expecting a bearish reversal and the market took off in the upward direction with strong bullish momentum? Well, you must have. Even the legendary investor Warren Buffett had such an experience. Almost every trader or investor has fallen into a bear trap at least once.
What is a Bear Trap?
A bear trap is a condition with a false signal indicating a strong downtrend momentum when the prices fall steeply but immediately rise with high buying pressure.
A bear trap is usually created by institutional investors or big traders to set up retail or naive traders to take short positions. During a bear trap, traders believe that the uptrend has ended as the prices fall sharply which encourages them to sell stocks and take short positions. The traders are fooled and are thus convinced to trade with confidence, only to see the market move upwards rapidly and they eventually have to incur huge losses. Since the traders need to buy back the stocks which they short-sold at higher prices, this helps the market rise even higher.
Bear Trap vs. Bull Trap
A bull trap is the exact opposite of a bear trap. The bull trap is set up similarly to the bear trap but in the opposite direction. In a bull, trap traders are lured into buying stocks expecting a potential strong uptrend only to see the price action fall towards the bottom.
Identifying a Bear Trap
The best way to avoid a bear trap and avoid loss is to identify a bear trap and take positions accordingly.
Here are some of the popular strategies to identify a bear trap.
Divergence is the condition when the technical tool and the price action no longer show the same momentum. The price action moves opposite to the direction shown by the technical indicator. Example – RSI (Relative Strength Index) divergence tool can be effectively used to identify a bear trap. If the price makes a lower low but the RSI indicator fails to do so, it is the signal for a bullish reversal.
If both the technical indicator and the price action are moving in the same direction, it signals a continuation of the trend.
2. Market Volume
Market volume essentially provides the most important sign for the market trend. Thus, most if not all the traders and investors rely on market volume to make trading decisions. If the trading volume is high during a breakout it confirms the continuation of the trend. High volume means more and more traders are willing to bet on the current trend.
On the contrary, if the trading volume is not significant it might be a bear trap. If the stock price falls with low volume then a potential bullish reversal is on the way.
3. Fibonacci Retracement Tool
Fibonacci series universally exists in nature. Fibonacci retracement tool has an uncanny ability to predict the support and resistance levels along with trend reversals of the stock market. Thus Fibonacci retracement tool becomes an important tool to identify a bear trap.
4. Reversal Candlestick Formation
Candlestick charts provide essential knowledge about the possible market trends. The given candlestick formations signal an upward market reversal.
- Morning star
- Harami, and
- Bullish engulfing
Similarly, reversal head and shoulders patterns and double bottoms candlestick patterns are very reliable reversal signals.
A Doji candlestick pattern shows the consolidation phase where there is uncertainty among the traders. You can wait for the market breakout after Doji formation to make the right trading decision.
Why Does a Bear Trap Occur (Reasons?)
a) Unexpected Political and Financial Events
The speeches of powerful political leaders or influential financial personalities can trigger a bear trap. We are familiar with the impact of the finance minister’s words in the NEPSE. These political leaders can make changes to certain policies which turn the tides against the current market trend. The central bank’s changing policies also play a vital role in executing a bear trap.
b) Strong Bullish Market Trend
If the market has been bullish for a long time then the institutional investors can set a bear trap. As a bearish trend is always on the cards after a bullish one, they take advantage of the trader’s emotions by creating a false breakout.
c) A Long Downtrend
In a strong and long downtrend, a bear trap might be seen. Since the market is in a long downtrend momentum the chances are less that it will continue to do so. Thus, this could be a false breakout below the support level. A bearish reversal is always awaited after a long downtrend.
How to Profit from the Bear Trap While Trading?
A bear trap becomes an occasion when most traders have to incur huge losses. But one can make a fortune of it if he/she can identify the bear trap. Using the above-mentioned methods you can detect and make decisions to make financial profits.
One can only profit from a bear trap if he/she identifies it with confirmation. Thus, after having a clear signal of a bear trap you can buy the shares in bulk and sell when the prices are up.
The capital market always provides an opportunity to earn profits, so does a bear trap. Interpreting the divergence, market volume, Fibonacci levels, and price actions correctly is the secret to success in the bear trap. These four signals are equally important in any other market situation.
It is best to avoid bear traps. One only loses more money than he/she can earn if caught in a bear trap. Observing reversal candlestick patterns and widening stop-loss orders (don’t place the stop-loss just below the support or the resistance levels). Patience is a crucial armory to avoid a bear trap and become a successful trader. You shouldn’t be carried away by emotions (don’t be too greedy or too scared) rather believe in the technical charts to make the proper decisions.
“Far more money has been lost by investors trying to anticipate corrections than lost in the corrections themselves” – Peter Lynch
From The Author:
(Liked this article??? If you are also interested in publishing your articles related to business, finance, and economics, then mail us your article at Investopaper@gmail.com.)