Bear Trap

What is a Bear Trap?

A bear trap is a technical price pattern that begins with a downtrend and a new lower low, which tempts traders to initiate or add to short positions. However, the price then reverses course and rallies instead of continuing down further.

This “traps” the new short sellers, who are might get forced to cover all their short positions by buying back the stock, often at a higher price than they shorted.

The bear trap frequently ends up in a short squeeze, where short-sellers get stopped out of their position after becoming too greedy.

Think of it like this. A stock is trading at its all-time-high of $100, and first short sellers come in. That might be a reasonable price level to go short.

However, let’s imagine the stock loses 90% of its value and falls to $10 within the subsequent 12 months. Is it now still a good time to short the stock? The risk of a bear trap, in fact, is now higher relative to the shorting scenario at $100.

Identifying a Potential Bear Trap

There are several potential clues that a downtrend may be a bear trap rather than a genuine continuation lower. These include the new lower low being made on diminishing downside volume and momentum, which signals the lack of conviction.

The price will also quickly reverse higher soon after making the new low, regaining the prior swing low area. Excessive new short interest at the lows can exacerbate the short squeeze once the tide turns back upward.

Consequences of a Bear Trap

For traders who get caught in a bear trap by shorting near the lows, the consequences can be quite painful. As the stock rallies, the short sellers are forced to entirely cover their short positions by buying back the shares, often at a higher price than they shorted.

This creates excess buying pressure that only adds fuel to the upside move. Bear traps can lead to immense losses for the trapped shorts and serve as an emotional and financial hit.

Trading Around Bear Traps

To avoid being trapped on the short side, traders need to be aware of potential bear trap setups and the warning signs. Using proper stop losses and position sizing can mitigate losses if caught in one.

Waiting for downside momentum to increase and retesting the lows before shorting can filter out many false breakdowns. Conversely, some traders look to buy bear trap bottoms by going long once the pattern and reversal is confirmed. Managing risk is key when looking to trade these tricky patterns.

Alexander Voigt, CEO
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Alexander Voigt is the founder of DayTradingZ, was a regular contributor to Benzinga and has been featured and quoted on leading financial websites such as Investors.com, Capital.com, Business Insider and Forbes.