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What is Bear Trap And How Does It Work

18 Aug 2023

Stock markets can be confusing and complex. There are a number of trading challenges that you may face in your journey to building wealth. These challenges pose a threat to your hard-earned profits. Understanding these pitfalls, how they operate, and what causes them can help you better grasp trading. The bear trap is a pitfall that can trouble even seasoned investors. Find out more about it to successfully evade it with greater insight and confidence.

What is a bear trap?

The bear trap is like its name suggests - a trap. The bear trap is a kind of pattern that shows up in stock trading. It starts with a sudden drop in prices. This drop tricks you into thinking the prices will keep falling, making you decide to sell your investments in a hurry. But then, when it seems like things are going down, the prices reverse and start back up.

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If you sell your investments when the prices are low because you think they will keep dropping, you could run into a problem. If the prices increase instead, you might have to buy back those investments at higher prices.

The term "bear trap" comes from this situation. If you believe the prices would keep falling and made decisions based on that, you might find yourself in a tough spot.

You can identify a bear market by looking at how the prices of stocks or indices are falling. A drop of about 20% or more from the highest point over two months indicates the market has turned bearish.

How does bear trap trading work?

Experienced traders closely watch market indicators and buy stocks when their prices are down. This is when many investors want to get assets at lower prices, but few sellers are around. To attract sellers, interested buyers start offering higher prices for those stocks.

The demand for stocks caught in the bear trap increases, making more people want to sell. This increased selling pressure messes up the buying and selling dynamic. The balance between high demand and low supply creates a negative market trend. It also stops the upward movement on the chart.

When you are caught in a bear trap, it makes you think there is a downward trend and that the investment price is dropping. But the value of the asset might not actually be falling. It could even go up. In that case, you might end up losing money. Some traders might start betting against an asset whose price is dropping, and others who usually bet on prices falling might do the opposite. However, in a bear trap, the trend suddenly switches in the opposite direction, catching many traders off guard.

How can you avoid a bull trap?

You can use trading tools like indicators and technical analysis. Tools like Relative Strength Index (RSI), Fibonacci levels, and volume indicators can help determine if a trend reversal after a stretch of steady price rise is genuine or just to attract short sellers. 

Keep an eye on a mix of factors when you are on the lookout. For instance, pay attention to the price sliding under a critical support level. This can signal trouble. Also, if the price does not close under critical Fibonacci levels and the trading volume remains low, these signals point toward a bear trap being set.

Another tip to remember is to steer clear of stocks that might be scaling new heights, like reaching a 52-week high or monthly peak. These situations might seem attractive, but they can sometimes lead you right into a bear trap.  

Additionally, unless you see a stock breaking down below its previous support level with conviction, it is wise to avoid getting entangled. This way, you can be cautious and avoid a potential pitfall.

To sum it up

Understanding potential pitfalls like the bear trap can help you preserve your profits. It is important to proceed cautiously, use reliable indicators, and prioritize risk management to navigate the market wisely. This way, you can be better equipped to overcome any twists in the market.

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