A bear trap is a situation when traders put on a short position when the price of a currency pair is falling, only for the price to reverse and move higher.
How a Bear Trap Works
There may be plenty of investors looking to buy stocks in some markets, but few sellers are willing to accept their bids. In this case, the buyers might increase their bid—the price they are willing to pay for the stock. This will likely attract more sellers, and the market moves higher because of the imbalance between buying and selling pressure.
However, when stocks are acquired, they automatically become selling pressure because investors only earn profits when they sell. Therefore, if too many people buy the stock, it will diminish the buying pressure and increase the potential selling pressure.
To increase demand and get stock prices to rise, institutions might push prices lower so that the markets look bearish. This causes novice investors to sell stock. Once the stock drops, investors jump back into the market, and the stock prices rise with the increase in demand.
How Bear traps Affect the Investor
A bear trap can prompt a market participant to expect a decline in the value of a financial instrument, prompting the execution of a short position on the asset. However, the asset's value stays flat or rallies in this scenario, and the participant is forced to incur a loss.
A bullish trader may sell a declining asset to retain profits, while a bearish trader may attempt to short that asset to repurchase it after the price has dropped to a certain level. If that downward trend never occurs or reverses after a brief period, the price reversal is identified as a bear trap.
Market participants often rely on technical patterns to analyze market trends and to evaluate investment strategies. Technical traders attempt to identify bear traps and avoid them by using various analytical tools that include Fibonacci retracements, relative strength oscillators, and volume indicators. These tools can help traders understand and predict whether the current price trend of security is legitimate and sustainable.