Have you ever seen a stock price drop and sold your shares only to watch the price climb back up? You may have gotten caught in a “bear trap,” a situation when an asset sees a sudden price dip before a consistent upward trend. Bear traps are frustrating situations for frequent traders — but if you know what to look for and understand your risk tolerance, you can avoid these situations. Read on to learn more about bear traps, how they form, and how to identify them.
What Is a Bear Trap?
A bear trap occurs when the price of an asset seems to be on a sudden, sharp decline — only to reverse its price trend shortly after beginning to drop. This causes “bears” (investors who believe that the asset's price will continue to decline) to sell their assets or take a short position. When the trend reversal is revealed, these bears often incur financial losses exiting the short position or purchasing the assets back at a higher price.
How Bear Traps Occur
Due to the psychology of herd mentality, multiple situations could cause a bear trap to occur. Investors tend to follow the “herd” of other investors, buying or selling depending on what the overall market is doing. A relatively minor piece of bad news or technical indicator can result in an asset losing value quickly. However, as soon as the market notices this overreaction, the price returns to its previous value.
Rapid declines in asset prices can also induce panic selling. Investors might interpret these drops as the beginning of a longer-term bearish trend — and when you see assets in your portfolio actively losing value, it can be difficult to avoid the temptation to jump ship and limit your losses. Of course, this doesn’t mean that every stock that declines in price will recover, illustrating the importance of differentiating bear traps from genuine market decline.
How to Identify Bear Traps
Identifying and avoiding bear traps is essential, especially if you’re a short-term investor. You can use both trading volume analysis and technician analysis to confirm the validity and strength of the downward price movement before making a buy or sell decision.
Trading Volume Analysis
Trading volume represents the total number of shares or contracts traded for a particular asset within a specified period. High trading volume indicates strong investor interest and participation, while low volume suggests the opposite. A price movement accompanied by a series of large volume movements may indicate that the trend is likely to continue.
When the price of an asset drops but the trading volume remains the same, it may indicate a bear trap. Genuine downtrends are usually accompanied by increasing volume as selling pressure intensifies. A low-volume decline suggests there is not enough conviction behind the selling, and the price might soon reverse.
For a downtrend to be reliable, it should be confirmed by comparatively higher trading volume. If the price breaks below a support level on low volume, it might be a false signal leading to a bear trap. Look for volume confirmation (where price movements are supported by a corresponding increase in volume) to validate the trend. Continuously track the trading volume for the assets you’re interested in, keeping your eyes open for unusually high or low trading.
Technical Indicators
Technical analysis is a type of investing analysis that relies on analyzing price trends and movements to predict future price movements. Paying attention to charting patterns and identifying indicators that signal a potential bear trap can help you avoid losses. Some of the most commonly used bear trap indicators include the following.
- RSI: The relative strength index (RSI) is a momentum oscillator that measures the speed and change of price movements. It ranges from 0 to 100, with higher values representing more investors using purchasing power. Traditionally, assets are considered oversold when the RSI falls below 30, while assets with an RSI value of 70 or more are considered overbought.
Assets with RSI values below 30 may be poised for a price rebound. If the RSI falls below 30 but then quickly rises back above this level, it can signal a bear trap, suggesting the downtrend was temporary. You may want to avoid selling when RSI values are frequently moving in the oversold direction.
- Stochastic oscillator: The stochastic oscillator is another momentum indicator that compares an asset's closing price to a range of its prices over a specific period. The oscillator ranges from 0 to 100, with readings above 80 indicating overbought conditions and below 20 indicating oversold conditions. Similar to the RSI, when the stochastic oscillator drops below 20, it indicates that the asset may be oversold. A subsequent rise above 20 can signal a bear trap, indicating a potential reversal.
- Candlestick charting: Candlestick charts allow you to visualize buying and selling data, knowing at a moment’s glance whether prices are trending upwards or downwards. Searching for specific candlestick patterns can help you predict bear traps. For example, the morning star pattern includes a series of downward candles followed by a small-bodied candle. This pattern often indicates that selling and buying pressure is about even — which often leads to a sudden price increase.
Strategies to Avoid Bear Traps
While bear traps can be daunting and unpredictable, there are steps that you can take to avoid falling into them.
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- Use stop-loss orders: A stop-loss order is an automatic order to sell a security when it reaches a predetermined price level. Setting a stop-loss order ensures that your position will be sold if the price drops to a certain level. This prevents further losses if the price continues to decline, protecting your capital. Knowing that a stop-loss order is in place can help you avoid panic selling during a particularly volatile price movement period.
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- Don’t forget fundamental analysis: Fundamental analysis involves evaluating a company’s intrinsic value by examining related economic and financial factors. Analyzing financial statements and industry conditions allows you to determine whether a stock is undervalued or overvalued. If a company's fundamentals are strong, a temporary price drop may be more likely a bear trap rather than the start of a long-term downtrend.
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- Confirm patterns before selling: Waiting for confirmation of technical patterns before making trading decisions helps ensure that you are acting on more reliable signals. Use multiple technical indicators to monitor and track negative price movements. If multiple signals associated with bear traps start to appear, avoid selling.
Investors who find themselves caught in a bear trap often find themselves there due to psychological pressure rather than incorrect analysis. Pay attention to your emotional state before placing a buy or sell order, and avoid letting fear or greed guide your decisions.
Stay Aware of Market Trends
As you have probably guessed, market trends and announcements play a major role in forming bear traps. Another essential step to avoiding bear traps is to monitor market news to understand why prices are moving the way they are. MarketBeat offers breaking headlines and daily market news to inform your trading. Bookmark your favorite stock news site and scan headlines before placing a sell order to find the cause of the sharp drop.
Invest Confidently with MarketBeat
Bear traps occur when investors see a negative price trend and jump in to sell or take a short position — only to see the price rebound. Bear traps occur when the market overreacts to a negative sentiment, causing the price to drop temporarily. You can avoid bear traps by performing thorough technical and fundamental analysis and taking a long-term view towards trading. Learn more about the latest market movements with MarketBeat’s premium research data.
