Crypto Dictionary

Bear Trap Explained

Learn how to identify and avoid bear traps in the crypto markets. Understand what a bear trap is, and how it works, as well as the risks associated with it and how to stay away from them.

When buying and selling in markets that deal with asset classes like equities, commodities, bonds, or even cryptocurrencies, novice traders are frequently caught off guard by price volatility.
 
Price reversals can baffle even the most seasoned traders, despite the fact that it is advised to stay invested for the long term to weather such periods of volatility. In order to avoid falling victim to them, it is crucial to spot indications of a false reversal or a temporary change in price direction before continuing the underlying trend.
 
A bear trap is a type of market manipulation that tricks bearish participants into thinking that the price reversal heralds the beginning of a downward trend. Then an uptrend is frequently sharply resumed after the bear trap.
 
Let us take a deeper dive into what a bear trap is and how you can avoid it.

Key Takeaways

  • Price reversals can baffle even the most seasoned traders.
  • It is important to spot indications of a false reversal or a temporary change in price direction. 
  • A bear trap is a type of market manipulation that tricks bearish participants into thinking that the price reversal heralds the beginning of a downward trend. 
  • A bull trap is a situation where there is a long-term downward trend and a short-term bullish trend. 
  • Technical analysis tools and trading indicators can help identify bear traps.
  • Bear traps carry the risk that if you sell too late, the rally that follows the decline will cause you to have to buy back at a higher price.
  • To stay away from a bear trap, it is best to hold onto holdings and place a stop-loss order before taking any positions.

What is a bear trap, and how does it work?

Technically speaking, a bear trap happens when the price action of a stock, index, or other financial instrument misinforms traders that an uptrend is about to turn into a downtrend. It is a type of market manipulation that is brought about by the coordinated efforts of a group of traders.
 
These traders will have enormous amounts of the underlying cryptocurrency. To put it another way, prices may increase broadly speaking only to run into significant fundamental resistance or change. As a result, bears start opening short positions in the hopes of making money off of a sign that prices are falling.
 
A bear trap in the cryptocurrency markets attracts both bearish and bullish bets, frequently with disproportionate risks involved. This mechanism is identical to that witnessed with other asset classes.

What is a bull trap?

A bull trap happens when there is a long-term downward trend in prices and a short-term bullish—or upward—trend. This brief uptrend can deceive traders into taking positions that could result in losses, much like a bear trap.
 
In a bull trap, traders might buy because the market is erroneously showing that a reversal is happening. Trading participants are left with stocks that are depreciating in value when the market resumes its downward trend. 

Identifying a bear trap

The use of charting tools found on most trading platforms can help traders identify bear traps, which are challenging for newcomers and require caution.
 
Technical analysis tools and trading indicators like RSI, Fibonacci levels, and volume indicators are typically needed to spot a bear trap because they can help determine whether the trend reversal following a stretch of steadily rising prices is genuine or just an attempt to entice shorts.
 
Even for technical traders, the basics are paramount in identifying a bear trap. The only thing that changes in a bear trap is the stock price because it is a false indication.

What are the risks of a bear trap?

Bear traps carry the risk that if you sell too late, the rally that is likely to follow the decline will cause you to have to buy back at a higher price. You will have to cover your short position when the price rises and accept your losses if you short into a bear trap without hedging your risk.
 
For instance, you decide to enter a short position at $100 after noticing a market decline. If the shares fall to $80, you can close your short position and profit by $20. However, if the market rises to $110 and resumes its upward trend, closing your short position will result in a $40 loss.

How to stay away from a bear trap?

Except if price and volume action validates a trend reversal below a critical and vital level, it is best for cryptocurrency investors with a low appetite for risk to stay away from trading through abrupt and unverifiable price reversals.
 
When this happens, it makes sense to hold onto your holdings and to hold off on selling unless prices have breached your stop-loss or initial purchase price. Understanding how cryptocurrencies and the entire market respond to news, sentiments, or even crowd psychology, is useful.
 
On the other hand, buying a put option is preferable to going long or short in the underlying cryptocurrency if you do want to profit from the momentum reversal.

Conclusion

Trading, particularly with cryptocurrency, is inherently risky. A bear trap could catch you at some point. The gamble is to take what you can from the crisis, minimize your losses, and go ahead once more. 
 
Bear traps are difficult to spot before they form and you notice your position shifting against you. It is always advised to place a stop-loss order before taking any positions. If so, it avoids the panic you might experience if the trend turns against you.

FAQs

How can bear traps be avoided?

Bear traps can be avoided by taking a long-term approach to trading and investing. This means focusing on fundamental analysis and avoiding short-term speculation. It also means avoiding heavily leveraged trading strategies and focusing on diversifying investments.

What is the difference between a bull trap and a bear trap?

The main difference between a bull trap and a bear trap is that a bull trap involves buying a security at a certain price level and then selling it back at a higher price. This is the opposite of a bear trap, which involves shorting a security at a certain price level and then buying it back at a lower price.

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