Bear vs Bull Traps: Strategies to Dodge Market Deceptions

Key Takeaways

•  A false indication of the reversal of a downward trend in the price of a security is referred to as a bear trap.

• Stock market bull traps can emerge when the price of an asset climbs above its level of resistance and draws in buyers looking to capitalize on the upside breakout.

• Paying close attention to price movements, trading volume and key technical indicators such as the Relative Strength Index can help traders avoid these traps. 

There are times when the price of a security can abruptly move completely counter to what a trader expects. This phenomenon is referred to as a whipsaw and tends to occur in volatile markets. Bull traps and bear traps can also occur as part of this pattern. These can impose significant losses upon traders if they fail to recognize the signs. This post explains bear vs bull traps in an effort to arm traders with strategies to dodge these market deceptions.

What is a Bear Trap?

A false indication of the reversal of a downward trend in the price of a security is referred to as a bear trap. Some traders may be tempted to short an asset in that situation, in order to realize gains from the decline. Similarly, bearish signals might lead them to sell off otherwise sound positions in an effort to cash out and minimize the potential for losses. Except, rather than continuing that downward trend, the share price rallies. The value of the asset resumes its upward trajectory—after the trader has relinquished their position. This can imposes losses as well as opportunity costs. 

How Bear Traps Form

An asset, the price of which has been enjoying an upward trend, can sometimes stumble into a short-term decline. The resulting price drop convinces traders and investors to move out of that asset—or take short positions in it.  In some cases, bear traps are intentionally created when institutions take actions to reduce the price of an asset. 

Once the price has fallen to a certain level, those institutions—and traders with more experience—take advantage of the lower price to acquire shares at a discount. The resulting demand then drives the price back up, catching short traders in a losing position and imposing losses upon investors who liquidated their positions prematurely. 

Identifying Bear Traps

Because they tend to be counterintuitive, identifying bear traps can be difficult to do. The best way to determine the potential for a bear trap (or a bull trap for that matter) is to apply fundamental and technical analysis. A company’s fundamentals are unlikely to change over the course of a few days without some significant occurrence, which will likely be discussed in financial news outlets. On the other hand, technical aspects can be fraught with extreme volatility. 

Useful technical indicators include the Relative Strength Index and volume indicators. 

Relative Strength Index (RSI)  – Calculating the RSI of a security can help investors determine whether an asset is currently over- or under bought. Essentially, the RSI provides a means by which the size and velocity of recent changes can be measured. A 14-day observation will usually suffice, but RSI can also be measured over longer time periods. 

The RSI calculation formula is as follows:

RSI = 100 – (100 / (1 + (average gains at closing/ average losses at closing))

To see this in practice, consider a situation in which an asset shows an average gain of 5% at closing against an average loss of 10% over a two-week period. 

The calculation would look like this:

RSI = 100 – (100 / (1 + 2 / 5))

      = 100 – 71.4

      = 28.6

The result here is less than 30%, which indicates the asset is oversold and a price increase is likely to ensue. On the other hand, the asset could be considered overbought if the figure had been above 70%. This could indicate a reversal of the trend is in the offing as investors take their profits.

Either way, a high RSI typically portends the potential existence of a trap. 

Volume Indicators – These can also be useful when it comes to identifying potential traps of both types. When trading volume is lower than what is considered average for a given security, the potential for bear (and bull) traps exists. Conversely, higher than average trading volume can be an indicator of momentum, which can be a sign of either strong upward trends or retreats.

Avoiding Bear Traps

A stop loss can help investors avoid a bear trap stock market. A trailing stop loss has the potential to be the most effective in this regard. The trailing stop loss will automatically close a position if the market rallies by a predetermined number of points, by which the trailing loss tracks the market. Maintaining portfolio diversification can also help investors avoid bear traps. 

Real World Bear Trap Example

Bath and Beyond had $3 billion in debt on its books and very little cash on hand in early 2022.  Share prices fell and many investors saw an opportunity for short selling in anticipation of the company going under. However, the stock rallied strongly in August of ’22. Share prices escalated to $23 from $5, then dropped to $1.66 at the beginning of 2023. Traders with short positions were forced to cover during that rally in what turned out to be a classic stock bear trap. The company went on to file a Chapter 11 in April of 2023, before being bought and resurrected as an online retailer by Overstock.com. 

What is a Bull Trap?

A stock market bull trap can emerge in an instance in which the price of an asset climbs above its level of resistance and draws in buyers looking to capitalize on the upside breakout. This increased activity then serves to push the price even higher. However, once that buying frenzy runs its course, the bull trap stock market price retreats. “Bulls” who took their positions as the price was on the upswing get caught out and are forced to either liquidate or endure losses. 

Bull traps tend to occur in bear markets when a falling share price suddenly does a 180 and begins to climb. Some buyers mistake this as the end of the downward trend and see it as an opportunity to make acquisitions. Bull traps can also happen in flat markets, as well as when an upward trend is petering out.

How Bull Traps Form

Sharp price upticks can incite fear of missing out on a potential opportunity. This can drive traders into taking positions in an asset with minimal analysis. Eager to realize gains, they will buy at the first sign of an upward trend, without checking the fundamentals. 

Trading on hope is often a faulty decision. Lacking solid evidence to support the sustainability of a price surge, these traders risk getting caught in a bull trap. 

When subsequent activity indicates others are not following them into the asset, they often rush to get out. This triggers a sell off, which incites price decreases and imposes losses. 

Additionally, experienced traders, who recognized there was no reason to be bullish about that asset, can see the surge as an opportunity to sell. This too, will serve to depress the share price. Long story short, emotional buys can result in traders falling into bear traps.

Examples of Bull Traps

While bull traps have a number of different indicators, the most common ones are a lateral trend in pricing, a weak uptrend, or a downtrend. A brief price movement above a prior high or resistance level is another clue, particularly when the price retreats below the prior high or resistance point. Instances such as these can be an indication of the need to sell to avoid greater losses. 

Trading volume is another indicator of a potential bull trap. Rising prices and low volume can signal optimism surrounding the asset in play is limited. In such a case the rally is likely to be short lived. Before taking a position in an asset that is suddenly on the upswing, experienced traders consider the volume of trades as well as the price. 

Other clues can be found by observing moving averages on longer term price charts and paying attention to breakout points—as well as key support and resistance levels. As covered above, calculating the Relative Strength Index of a security can provide clues to the potential for a bull trap as well as a bear trap. These metrics can help traders recognize overbought and oversold conditions. 

Bull vs Bear Traps and Portfolio Diversification

Paying close attention to the signals the market sends can help traders avoid falling into bull traps, as well as bear traps. Being careful to maintain portfolio diversity can also help traders avoid losses.

Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform. However, that meant the potentially attractive  gains these investments presented were also limited to these groups.

To democratize these opportunities, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other alternative investments. 

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10,000.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

Exercising caution, as well as performing strict due diligence when trading is the best way to avoid bull and bear traps. Low trading volume and divergence between price and momentum are clues to both types of traps. Paying close attention to price movements, trading volume and key technical indicators such as the Relative Strength Index can help traders avoid these traps.