If you have been in the crypto industry for a while now, you have probably heard the terms bear and bull. If not, we will explain them in a few words.
A bear market is considered a slow or dipping market, while a bull market is considered a growing market.
Other than the terms bull and bear, there also exist a bear and a bull trap. This article will focus on the bear trap and explain how you can avoid it.
What Is A Bear Trap?
In simple words, a bear trap is when a stock, index, or any other instrument signals a ‘false’ reversal from a downward trend to an upward one.
In other words, a bear trap is a controlled selling that creates a temporary dip in the prices of assets. Novice traders are often surprised by price volatility when trading in markets that specialize in asset classes such as stocks, commodities, bonds, and even cryptocurrencies.
Investing for the long term is recommended to survive such volatility, but price reversals can confuse even experienced traders. Therefore, to avoid falling victim to them, it is important to look for signals of false reversals and temporary changes in price direction before the underlying trend resumes.
How Does A Bear Trap Work?
In some markets, there may be many investors looking to buy shares but few sellers willing to bid. In that case, the buyer can increase the bid price. This will likely draw more sellers to the market, and the disproportion between buying and selling pressure will drive the market higher.
However, when a stock is bought, the stock is automatically put under selling pressure because the investor must sell it to make a profit. As such, too many people buying stocks can lead to less buying pressure and more selling pressure.
In an effort to increase demand and push stock prices higher, institutions can push prices down, making the market look bearish. This encourages inexperienced investors to sell stocks. When stock prices fall, investors jump into the market again, and as demand increases, stock prices rise.
Bear Trap Example
The best way to explain a bear trap is the history of Tesla stock (TSLA). This is probably the previous generation’s most famous ‘story strain.’
The company has attracted loyal supporters and detractors and has put a large chunk of its fortune into the deal. Without Elon Musk‘s fanfare and flashy marketing, Tesla would have been an ordinary automaker to most people, building expensive cars in a new and uncertain industry.
Some of the most revered short sellers like Jim Chanos and David Einhorn are passionate Tesla bears. They complain about accounting, affordability, and ratings.
As Tesla went from being a small niche company to its current dominance, short-sellers continued to elevate their position, citing all the bearish catalysts. And at every point so far, their position has been decimated. Like it or not, Tesla has become a bear trap machine.
How To Avoid A Bear Trap?
There are several ways you can avoid a bear trap. The best one is considered to be technical analysis.
The volume of the prices is easily understandable and usually displayed on most trading terminals. Therefore, if the volume significantly decreases, it might be a bear trap. Below are some guidelines on how to avoid being trapped in a bear trap.
Look for indicators that are diverging. If an indicator is moving against the price, a signal is created. This discrepancy indicated a high likelihood of a bear trap. When you see that a bear trap might develop, use technical indicators such as the RSI (Relative Strength Index). These indicators measure the pace and change of price changes and can be useful in anticipating the next price movement.
Bear traps often occur when the price of a stock exceeds the broker’s equity requirements. Short sellers will have to liquidate their bets and deposit additional cash or risk incurring more considerable losses. Bear traps are exceedingly harmful to all levels of investors and traders.
Takeaways
- A bear market is considered a slow or dipping market.
- A bull market is considered a growing market.
- A bear trap is when a stock, index, or any other instrument signals a ‘false’ reversal from a downward trend to an upward one.
- When a stock is bought, the stock is automatically put under selling pressure because the investor must sell it to make a profit.
- The best way to avoid bear trap is by using technical analysis.
