What is a bear trap in trading and how to avoid it?

Bear traps can be difficult to identify. Typically, they only become apparent when a short squeeze escalates and the trade has gone bad.

It remains important to always conduct research before your trades and plan your operations. To do this, it is interesting to perform both a fundamental analysis and a technical analysis to understand the main governing elements of an asset. It is unlikely that a company’s fundamentals will change drastically in a matter of days. However, technical data can change quickly. These are generally what you want to focus on when identifying a bear trap.

Technical analysis includes a wide range of indicators that can be used to identify important support and resistance levels. These indicators include the Fibonacci retracement tool, moving average (MA), moving average convergence/divergence (MACD) and Bollinger bands. You can monitor a stock’s short selling activity to determine how crowded it is.2.3 The larger the size of short positions (in terms of percentage of float or average daily volume), the more likely a bear trap will form where more traders may be forced to cover their short positions.

While bear traps in the stock market can be brief, they are usually characterized by a pronounced upward movement accompanied by increased volumes. If the price of a security moves with high volume, the credibility of the movement increases.

Example of a bear trap

The American company Bed Bath & Beyond Inc has experienced several bear traps. In 2022, the company’s fundamentals were weak as its debt stood at around $3 billion and its balance sheet highlighted low liquidity. Given these difficulties and investors’ doubts about whether the company could survive, traders sensed an opportunity for short selling.

The Bed Bath & Beyond company’s share price has experienced several sharp recoveries that could be considered bear traps. The largest occurred in mid-2022. In June and July of the same year, the share price was falling. But in August the price began to recover, slowly at first, then more sharply. It went from about $5 to $23.

In this example, both volume and share price have been increasing with acceleration. These increases could have warned investors about the formation of a bear trap. The stock price eventually experienced a sharp reversal, falling to $1.66 in January 2023. But for short traders, it was already too late. Many had to cover their positions as the share price recovered strongly and the losses became too great to reverse. They were caught in the bear trap.

Although the company’s fundamentals have remained weak, the share price has experienced several significant upturns. Technical analysis can help identify bear traps like this when trading.

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