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A bear trap is a colloquial name for a particular trading pattern in the stock market. Essentially, it’s a relatively sudden movement in a stock or in the broad market that lures in investors who attempt to bet on future losses. However, in a true bear trap, the market soon reverses again back the other way, “trapping” these negative-minded investors. But, how did a bear trap get its colorful description, and what does it really mean for the average investor? Here’s an exploration of all of the ins and outs of what a bear trap in trading really is.
Read: Looking To Diversify In A Bear Market? Consider These 6 Alternative Investments
What Are Bulls and Bears?
In order to understand what a bear trap is, it’s helpful first to understand the Wall Street terms “bull” and “bear.” Generally speaking, a bullish investor is one who believes that the market — or an individual stock — will go up in price. A bearish investor is the opposite, betting on a decline in prices. The terms are said to derive from the attack positions of the respective animals, with bulls goring upwards and bears swiping down. However, the true reason for the names is lost to history.
The terms bull and bear also apply to general market movements. For example, a market that has dropped by 20% or more is often said to be a bear market, while a reversal to new highs starts a new bull market.
Bearish investors try to take advantage of market downturns in a number of ways. Some simply sell their stocks and stand by the sidelines as they watch the market fall, while others are more proactive and actually seek to profit from a selloff. One way to do this is to sell stocks “short,” which is a trading strategy that requires an investor to borrow shares of stock from a firm and sell them in the open market. The idea is that if prices continue to fall, the short investor can buy those shares back at a lower price in the future. A profit is made if the price of the buyback is lower than the price at which the shares were originally sold short.
Why Is It Called a Bear Trap?
A bear trap is a trading pattern in which the prices of an individual stock or the market as a whole drops sharply, only to reverse shortly thereafter. At the time of the original decline, bearish investors may be lured into selling stocks short, attempting to capitalize on the falling prices. But when prices reverse sharply thereafter, these bears are “trapped” in their short position, losing money every day that prices continue to rise.
The idea behind calling this type of trading pattern a bear trap is that bearish investors are sitting and waiting for prices to fall so they can jump in and profit from short positions, but instead they are trapped when prices reverse course and head higher. Those bearish investors are now trapped in their losing positions.
What Does the Technical Trading Pattern of a Bear Trap Really Look Like?
Bear traps are identified by market technicians, who use the past price movements of stocks and markets to guide their trading. Although technical patterns and terms can be a bit overwhelming for the beginning investor, it’s good to have a basic understanding of them.
A “support level” in a stock or index occurs at a level at which investors have previously bought stocks. Generally, stocks tend to bounce higher off these levels, as investors are again enticed into the market and thereby provide support for shares.
When markets break through so-called “support” levels, technicians suggest that further selling lies ahead. While this may often be the case, sometimes a break, lower through support levels, reverses shortly thereafter. This is the technical definition of a bear trap. Investors expect the break lower to be the precursor of further selling, but they get trapped when prices resume going higher instead of continuing to fall.
How Do Bear Traps Affect Average Investors?
Bear traps don’t have any real effect on the typical long-term, buy-and-hold investor. For starters, the average investor has a bullish bias, hoping and even expecting that the stock market will rise over time. Betting against the market by taking a short position isn’t usually in the arsenal of the average investor. In fact, for bullish investors, bear traps actually represent an opportunity. When prices fall, long-term investors can usually benefit by buying additional shares at lower prices. If the market returns to new all-time highs after the selloff — something which has always happened, historically speaking — these bullish investors eventually benefit from the rise in prices.
Of course, just as there are bear traps in the market, there are also bull traps, and these may be more likely to trip up the typical investor. Acting in an opposite manner to a bear trap, a bull trap trading pattern is represented by a sharp increase in prices that draws in bullish investors, only to have those prices rapidly turn around and fall. Investors that piled into the market hoping to ride the trend of higher prices are then faced with the prospect of immediately losing money on their positions.
The Bottom Line
Bear traps are something of a stock market “head fake,” luring in bearish investors and then whipsawing them as prices resume their upward climb. The good news is that for the average investor, bear traps are a non-event, and perhaps even an investment opportunity. But if you are a bearish investor by nature, a bear trap represents a dangerous trading pattern that could cost you money. It’s best to be fully aware of how bear traps operate before you step into the world of selling stocks short and attempting to benefit from price drops.
Information is accurate as of Sept. 19, 2022.
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Bear Trap in Trading: Explanation for Beginners - GOBankingRates
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