In this detailed guide you will learn more about what a bear trap is in crypto trading, how to identify it and how to avoid it effectively.
The cryptocurrency market is highly volatile and unpredictable. An experienced trader should watch out for various pitfalls that can take him out of his trading strategies. One of these traps happens to be the bear trap.
A bear trap refers to an investment practice in which a sharp drop in the price of a cryptocurrency can entice traders to bet on the trend, only for the trend to turn out to be false and the asset to rise shortly thereafter, forcing traders who have shorted the market to close their positions or liquidate them through a margin call.
In most cases, crypto bear traps can cause investors who short a digital asset to suffer losses, regardless of the token's long-term prospects. Crypto bull traps and bear traps are common, and investors may initially find them difficult to identify. However, it is not impossible to spot them with the help of technical analysis.
This guide will help you understand how bear traps work, what they mean for crypto traders, and how to navigate them.
What Is a Bear Trap, and Why Does It Happen?
A bear trap refers to a technical pattern that happens when a new bearish trend in cryptocurrency or stock price appears (typically with short sellers driving down the market) only to witness a reversal and experience a rising price trend. A short squeeze in a market is also similar to a bear trap. However, the effect of a short squeeze can be more intense as the prices can surge very quickly in short amounts of time.
Bear traps lure traders, especially beginners, into a false panic. This causes them to sell the assets they own, expecting a continuation of the bear market, which may not happen. Instead, the crypto market could turn around and go up, entrapping token sellers in their short positions. In such cases, traders must exit their positions before the uptrend reaches their selling price point, or risk losing all their money.
Unlike the bull trap in cryptocurrencies, the bear trap can be devastating for traders with short positions. For the uninitiated, a short position means that the investor borrows a crypto asset, sells it, then buys it again later (hoping for a lower price), thus taking advantage of the downward trend in the crypto market. Traders can usually sell short using futures on most digital assets in the market.
Bear Trap: Meaning and Examples
A crypto bear trap happens when a digital asset that is losing value reverses direction and begins to appreciate. The trap can also occur when a coin that is poised to drop unexpectedly holds an uptrend. Traders with bearish sentiments who bet against the coin end up suffering losses.
The spike in the value of the cryptocurrency and the corresponding loss may cause novice traders to invest more money or sell their shares at a loss. For example, a trader who intends to short the XYZ cryptocurrency buys it for 40 USD, and the coin experiences a downward price movement.
XYZ drops to 35 USD, which means that the trader should get a profit if he closes the position at that point of time. Before closing the position, however, XYZ starts to rise and reaches 45 USD. If the trader closes the position now, he will suffer a loss of 5 USD per coin. Depending on the number of shares (coins or contracts) sold short and the amount of capital remaining, the trader's broker may ask him to deposit more funds or block further losses by forcefully closing (liquidating) the position.
Even if the surge in value is short-lived and XYZ later resumes its downtrend, the bear trap would force the trader to close the position or invest more funds. On the other hand, if the cryptocurrency continues to move up, the losses will grow until the trader closes the position.
Consider what happened with the Tesla (TSLA) stock, also known as "story short," as another example.
It's no secret that without the reputation of Elon Musk's name and sophisticated marketing strategies, Tesla would be a simple electric vehicle manufacturer. However, its expensive cars put the automaker far ahead of the competition. While popular automakers like General Motors and Ford are valued at $35 billion and $12 billion in market capitalization respectively, Tesla has a market capitalization of a whopping $650 billion.
Some of the most iconic short sellers like David Einhorn and Jim Chanos are Tesla bears who have raised questions in the past related to financial viability, accounting and valuation.
As Tesla has morphed from a mere niche company into the dominant one it has now become, short sellers in the market have used bearish catalysts to add more to their position. In many such moments, their positions were summed. This is why many experts believe Tesla has become an ecosystem with bear traps. Take a look at the chart below showing some short squeezes seen in TSLA.
How To Identify a Bear Trap Pattern: Technical Analysis
Crypto bear traps can cause traders significant losses. To minimize this risk of loss, it is best for traders and novice investors to know how to identify a bear trap.
Traders can use a variety of technical trading tools such as Fibonacci retracements, volume indicators and relative strength oscillators to distinguish a crypto bear trap from an actual trend reversal. If a strong bullish price trend is suddenly interrupted by a suspicious downtrend, instead of succumbing to it, traders should look at other market parameters to understand why it happened. If you don't see any remarkable change in market sentiment that is the cause of the trend reversal, it is probably a bear trap. Here are some common indicators that can help you recognize a bear trap.
Some market indicators act as divergence signals, and divergence usually indicates a bear trap. To spot the divergence, you need to check if the price of the crypto asset and the set indicator are moving in opposite directions. Traders use this to decide if a bear trap may be occurring. The absence of divergence means that it is unlikely to be a bear trap.
Analyzing cryptocurrency trading volume can help you detect a potential crypto bear trap pattern. Typically, when the market shifts down or up, traders may notice high trading volumes in the market along with that movement. The reason for this is simple. Whether the market’s direction moves down or up, traders try to take advantage of the opportunity or recover their losses.
However, a downward trend with low trading volumes indicates a potential bear trap.
Fibonacci retracement levels refer to horizontal lines that indicate where cryptocurrency prices are likely to meet a level of support or resistance. If the price of cryptocurrencies in the market drops but does not break Fibonacci levels, it can be assumed that the drop is questionable and may not hold.
Fibonacci levels demonstrate reversals in the value of cryptoassets in the market as trend reversals are determined using fibonacci ratios. This makes them a great indicator of crypto bear trap patterns that are likely to happen when the price does not break any Fibonacci level.
The Relative Strength Index (RSI) is a momentum oscillator that helps track the speed and change of price movements. An RSI less than 25 generally demonstrates oversold conditions ready for a move upward. An RSI bigger than 75 suggests overbought conditions ready for a move downward.
Another instrument in bear trap trading, the RSI helps predict price reversals.
The red trend lines at the bottom indicate two oscillators, the MACD and RSI. Both of them are trending noticeably upward before the sharp price break.
Bear Trap Chart Patterns
By studying the movement of bear trap candlesticks in technical analysis, traders can understand more about common bear trap chart patterns. For the uninitiated, a bear trap candlestick is a candlestick that either
- Breaks the support level and closes under it
- Breaks the support level and closes above it
Soon after the bear trap candlestick builds, the coin price tends to move up. Below are three chart formations that provide good buy signals and help predict/understand bear traps.
Bear trap chart 1
This chart features a bearish bear trap candlestick that breaks and closes below a support price level. Note that the next one or two candlesticks after the breakout can be bullish reversal candlesticks or display bullish momentum.
Bear trap chart 2
This chart features a bullish bear trap candlestick that breaks the support level and goes down but eventually closes above the support line forming a bullish candlestick.
Bear trap chart 3
This chart features a bearish bear trap candlestick that breaks the support level and goes down but closes above the support level. The next one to two candlesticks could be bullish.
How To Avoid Bear Traps in Crypto Trading?
Bear traps can be very risky, and the best way to not incur any losses from bear trap trading is to avoid them. Here are some expert-recommended ways that can help you avoid getting caught in a bear trap:
1. Observe trading volumes: Trading volumes reflect the strength of the bear market. If an indicator shows no signs of an uptrend, there is little chance that the price will continue to fall under bearish pressure. It is best not to enter the market at this time.
2. Avoid shorting: One of the easiest ways to avoid heavy bear traps is not to take short positions, which can lead to significant losses when the market rallies. If you decide to trade a short position, choose a stop-loss and understand the risks. Determine how much of your investment portfolio you can risk based on your priorities and tolerance and trade accordingly.
3. Steer clear from illiquid markets: In illiquid markets where not many investors and traders are involved, bear traps are more frequent. Avoiding illiquid markets can directly help prevent bear traps.
4. Risk management: Good risk management is the best way to handle any trade. Even experienced investors can't predict market trends with 100% accuracy, therefore, don't risk more than you're willing to lose.
How To Trade Bear Traps in Crypto: The Best Strategies
In the crypto space, bear traps are a common pitfall. Traders and novice investors must be careful while trading bear traps. Here are some tips to keep in mind while doing so to minimize the risk of losses.
It is a good practice to widen your stop-loss orders and not place them under the support level. They must provide a buffer zone that can work as a breather for you when price drops or false breakouts happen.
Bear traps occur when there is a price fall, so remember to check the length of downtrends. Understand how long the trend has been happening and avoid entering the market during a prolonged downtrend.
Another key strategy is to get out of crypto bear traps as soon as you spot them. One method is to place a stop-loss order that can trigger as soon as you identify an upward reversal. When trading cryptocurrencies, you need to be agile to avoid getting caught on the wrong side of the market.
Lastly, remember to hand-pick and use multiple technical trading tools like Fibonacci retracements, RSI, and volume indicators to differentiate a bear trap from a real price reversal.
A bear trap is an occurrence that traders cannot underestimate. If you are a novice investor, you may initially find it difficult to detect such traps on the trading chart beforehand. But with the help of market indicators and some experience, you will learn how to recognize them and stay away from them. If you encounter a sudden downtrend and are unsure how to react, be sure to apply a stop-loss. Essentially, this will mean that you won't lose any more money than you planned.
Trading is inherently risky, especially in the crypto space. At some point, you may run into a bear trap. The important thing to remember is to learn from the experience, minimize losses, and get back on the right track.
What does Bear trap mean in crypto trading?
In the crypto space, a bear trap is a technical pattern that occurs when the performance of a cryptocurrency signals a reversal of an upward price trend. Sometimes such price reversals instead turn into follow-through buying, trapping traders in their short positions.
How do you know if it is a bear trap?
A bullish investor may sell a falling crypto asset to retain profits, while a bearish investor may attempt to short the coin in order to purchase it back after the value has dropped to a certain level. If that downward trend does not occur or reverses after a period, the price pattern can be identified as a bear trap.
How do you stop a bear trap?
Traders can try to identify a bear trap using different volume or technical indicators. One of the simplest ways to prevent a bear trap is to avoid short selling. If you decide to trade a short position, ensure you set a stop loss and understand the risks.
How do you trade a bear trap?
Seasoned traders typically keep a tab on market trends and purchase cryptos when prices fall. During this time, most investors would want to buy assets at lower prices but hardly find any sellers. For experienced traders, this is the perfect time to make novice crypto investors sell their assets at a lower price.