Because any market responds to price signals, a group of investors with deep pockets can arrange to sell an asset. This creates a selling pressure, which is when a bear trap is triggered, ending with those same investors buying the asset at a discount.
Originating from the stock market, a bear trap is often encountered in stocks that are perceived as overvalued. In other words, those stocks are trending outside of reasons of their valuation, profit-to-sales ratio (P/S), and long-term market positioning. Whether one is investing in cryptocurrencies or stocks, a trader can commit to two positions when entering the market.
- Betting that the price of an asset will go down - short position (also known as short put or short call).
- Betting that the price of an asset will go up - long position (also known as long put or long call).
The balance between shorts and longs creates price pressures which can either be bearish - price goes down, or bullish - price goes up. Taking advantage of this dynamic, investors can place large short puts. In turn, they create a technical indicator that a price reversal is going to happen - from up to down.
Therefore, other investors then see that bearish momentum is coming, triggering them to place short puts of their own. Then, two things can happen. If the shorted asset maintains the price or even goes up (rallies), the original investors suffer a loss.
If not, other investors will place shorts on the declining asset's price. They do this because they expect a real bearish momentum, not a bear trap. Correspondingly, they count on making a profit from their short positions. However, the bearish momentum never completes.
Bear trap pattern | Image Source: PatternsWizard
Instead, it reverses because the original investors are now buying up the asset at a discount. This is the bear trap. Most commonly, due to the volume of short calls that have to be placed in order to trigger such a market signal, whales conduct bear traps.
Otherwise known as institutional investors, they trigger bear traps in three ways:
- Identifying the asset's support level through technical analysis
- Identifying moving averages (MA)
- Identifying the asset's trading volume because it will increase whenever there is a momentum to either a new low or new high
As you can see, whales who trigger bear traps count on other traders to snowball their initial shorts. This is a reasonable expectation as many investors try to "win back" their losses instead of cutting them. However, there are some technical indicators that can help identify a bear trap vs. organic bearish momentum.
For example, Aroon indicator, Fibonacci retracement, relative strength oscillator, volume indicator - all can help to predict whether the bear/bull trend is sustainable or not. In this distinction lies the difference between a regular price move and a bear trap.
ELI5 Bear Trap
As opposed to bull trap, a bear trap is a false indication of a downswing in the market. It is when people are tricked into selling assets, only to have them go up soon.