Bear Trap

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Definition: Bear Trap


Bear Trap


What is the dictionary definition of Bear Trap?

Dictionary Definition


A bear trap occurs when a declining market reverses direction, catching short-sellers off guard. In a bear trap short-sellers, who have continued selling in anticipation of a further drop in a now-bullish market, are eventually forced to buy back stock at a higher price to cover their positions. A bear trap can also be created by a temporary downturn in an otherwise bullish market, tricking short-sellers into stepping into the bear trap just before prices again begin rising. Obviously, short-sellers wish to avoid the bear trap. The bear trap primarily exists due to the difficult nature of market timing. If short sellers had a way of knowing with certainty that a bearish market had turned bullish, the bear trap could be easily sidestepped. Unfortunately, such market timing is difficult at best, leaving many short sellers at the mercy of the bear trap with each market swing.


Full Definition of Bear Trap


A bear trap is a technical pattern that happens when a stock’s, index’s, or other financial instrument’s price action wrongly implies a reversal from a negative to an upward trend. Institutional traders, according to a technical expert, strive to set up bear traps to entice regular investors to take long positions. If the institutional trader succeeds and the price rises briefly, it allows institutional traders to dump greater stakes of stock that would otherwise cause prices to fall dramatically.

  • A bear trap is a false technical indication of a market reversal from down to up that can entice unsuspecting investors.
  • These can happen in any asset market, including equities, futures, bonds, and currencies.
  • A bear trap is frequently triggered by a decline that causes market participants to open short sales, which then lose value in a reversal when the shorts must be covered.

In some markets, there may be a large number of investors looking to buy stocks but a small number of sellers willing to accept their bids. In this case, the buyers may raise their bid—the amount of money they are willing to pay for the stock. This is likely to attract more sellers to the market, and the market will rise as a result of the imbalance in buying and selling pressure.

When stocks are acquired, however, they automatically become a source of selling pressure because investors only profit when they sell. As a result, if too many people buy the stock, the buying pressure will be reduced while the potential selling pressure will increase.

Institutions may lower prices in order to increase demand and cause stock prices to rise, making the markets appear bearish. As a result, inexperienced investors sell their stock. When a stock falls in price, investors rush back into the market, and stock prices rise in tandem with the increase in demand.

Considerations

A bear trap can lead a market participant to believe that the value of a financial instrument will fall, prompting the execution of a short position on the asset. However, in this scenario, the asset’s value remains flat or rises, forcing the participant to incur a loss.

A bullish trader may sell a declining asset in order to keep profits, whereas a bearish trader may attempt to short that asset in order to buy it back once the price has dropped to a certain level. If the downward trend does not occur or reverses after a short period of time, the price reversal is referred to as a bear trap.

Technical patterns are frequently used by market participants to analyse market trends and evaluate investment strategies. Technical traders use a variety of analytical tools, such as Fibonacci retracements, relative strength oscillators, and volume indicators, to identify and avoid bear traps. These tools can assist traders in determining whether a security’s current price trend is legitimate and sustainable.

Short Selling vs. Bear Traps

A bear is a financial market investor or trader who believes that the price of a security is about to fall. Bears may also believe that a financial market’s overall direction is deteriorating. A bearish investment strategy seeks to profit from a drop in the price of an asset, and a short position is frequently used to carry out this strategy.

A short position is a trading strategy that involves borrowing shares or contracts of an asset from a broker using a margin account. The investor sells the borrowed instruments in order to repurchase them when the price falls, thereby profiting from the decline. When a bearish investor incorrectly identifies a price decline, the risk of falling into a bear trap increases.

Short sellers are forced to cover positions as prices rise in order to limit their losses. A subsequent increase in buying activity may spark additional upside, fueling price momentum. The upward momentum of the asset tends to decrease after short-sellers purchase the instruments required to cover their short positions.

When the value of an index or stock continues to rise, a short seller risks maximising the loss or triggering a margin call. Stop losses can be used to limit the damage caused by traps when executing market orders.


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Definition Sources


Definitions for Bear Trap are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

This glossary post was last updated: 5th April, 2022 | 0 Views.