Trading terminology can be confusing for first-time traders and investors, especially in the crypto markets where new terms (often based on memes) pop up on a regular basis.
In this guide, you will learn what a bear trap is and what you need to look out for when you spot one.
What is a bear trap?
In the crypto markets (and the traditional financial markets), a bear trap is a price pattern that falsely indicates a potential price reversal that suggests an asset may be declining in value, just to shoot up again, continuing its upward trend.
It’s called a bear trap because bearish traders and investors that see the price reversal may sell or short-sell the asset, just before it starts to rise in value again, creating trading losses for bears.
How does a bear trap occur?
A bear trap can be a form of coordinated and controlled selling of an asset to create a temporary downtrend in its price, involving several traders who have significant holdings of a cryptoasset colluding to sell large portions of cryptocurrency at the same time.
The purpose of this action is to convince market participants that a price correction is happening, and the need to liquidate their positions ultimately drives down the price of the asset.
Once the price declines to a certain level, the bear trap is released, and the colluding traders will buy back the assets at a reduced price. The value of the cryptoasset will start to rise, and the traders can profit from the price movement.
Bear traps can happen over several days or within a few hours. Overall, a bear trap is often sudden and short-lived, persuading bullish market participants to short the underlying asset in anticipation of a price downtrend that can lead to some loss. The aftermath of the sudden price decline is sharp as the previous uptrend.
Bears who sold the cryptocurrency short will be liquidated if they get caught in a bear trap, resulting in trading losses.
How do you spot a bear trap?
You can identify bear trap patterns using technical analysis. Let’s take a look at a handful of chart analysis indicators to assist you in identifying this price pattern.
Analyzing crypto trading volumes could assist you in spotting a potential bear trap.
Normally, when there is a significant market movement, either upwards or downwards, you will notice high volumes accompanying the shift. This is the result of traders trying to take profits or cover losses.
A drastic decline in the price of an asset with a low trading volume could signify a potential bear trap. This means several investors have sold, causing the price of the asset to drop.
Fibonacci price levels are trend lines that suggest where support and resistance are likely to happen. You may be able to spot a potential bear trap when the price of a cryptoasset is dropping but does not break the Fibonacci levels.
Relative Strength Index (RSI) indicator
The RSI is a tool used to track the price momentum of an asset. An RSI of below 25 denotes a bearish momentum that is ready for an uptrend, and an RSI greater than 75 suggests a bullshit momentum that could lead to a downward price move. The RSI is a useful tool when trying to predict price reversals as it indicates whether the asset’s price momentum is bullish or bearish.
While technical indicators can help you to potentially identify a bear trap versus an actual price trend, they should never be used as standalone indicators but always in conjunction with other indicators or trading tools.
How do you trade a bear trap?
A bear trap distorts the market and affects traders since it involves the asset undergoing a price reversal that is opposite to the primary bullish trend, before changing course and resuming its upward journey.
As a result, there are several ways you can approach bear traps.
Firstly, you can just HODL your investment if you plan to hold it for the medium to long-term. In fact, if you are planning to HODL, there isn’t much point in looking at charts at all.
Secondly, you could put on an options trade (provided there is a liquid options market), such as a long strangle, that allows you to profit from the increased volatility in the asset.
Thirdly, if you are convinced you have spotted a bear trap, you could put on long positions at reduced levels, setting your stop-loss below the level where you think the trend will reverse back to its original upwards trend.
While trading based on charts and technical indicators has become very popular in the crypto markets, it’s important to remember that neither charts nor chart analysis tools can predict the future. Especially in a highly volatile market like crypto, traders need to take a wide range of tools, trade flow, and news into account to make an informed trading decision.