Bear Trap Trading Strategy

Bear Trap Trading Strategy (Rules, Backtest, Performance)

While you might not have known it by its name, you would have fallen victim to the bear trap, especially if you love “calling the top” of a reversal trade.

Have you ever tried entering a short trade thinking the bullish trend is losing momentum and the price of the security you’re trading is about to bite the dust, only for you to receive a margin call? Then, you’ve just fallen victim to the bear trap.

In this article, we will cover what the bear trap is, how to spot it, answer a few of your questions, and show you how to avoid it in real-time. Let’s get straight into it and discuss the bear trap trading strategy.

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What is a Bear Trap in Trading?

Picture this: you are on your typical day, trying to scan through the market and analyze your favorite trading pair or stock. The price has been forming a succession of higher highs and higher lows, indicating the price is soaring high; it begins to look like the price has taken off without taking you along on the ride.

Suddenly, a bearish candle broke the last support zone in what looked to you as the best breakout setup of the ages. Not wanting to miss this opportunity again, you jumped in immediately, only to be welcomed by a large bullish candlestick that took you out of position. Game over.

Now, let’s take a step back and see what just happened. The trading market is a pool of liquidity with a lot of traps. One of those traps is the bear trap.

Bear trap pattern occurs in an uptrend market where the sellers are tricked into believing there will be a reversal when a bearish candle quickly breaks a significant low, only to issue a bullish candle that takes the sellers out and continues the former trend.

This move capitalizes on one of the fears plaguing retail traders: Fear of missing out (FOMO).

Why is it Called a Bear Trap?

In the world of trading, while the term bear might have gotten its origin from observing how bears attack their prey (by beating them down), it means something different.

A bear is an investor who believes that the value of a particular asset will diminish with time. Hence, the price of that asset will drop. When these investors commit to this decision in the market, it is called “shorting.”

So why the name “bear trap”? It is so named because as the bear investor pursues shorting positions across different asset classes or securities, he is tricked by price, just like a bear is tricked into a physical trap. Still, before he knows it, his money has been taken away.

How Do You Spot a Bear Trap?

Spotting a bear trap in the stock market (or other markets) can be a challenging task, even for experienced investors. This is because bear trap patterns are often disguised as a continuation of a downward price trend and can be difficult to distinguish from other chart patterns.

One of the critical characteristics of a bear trap pattern is a sudden and sharp price reversal after a prolonged period of upward movement. This reversal can be seen on a stock chart as a series of higher highs and higher lows, followed by a sudden and steep decrease in prices.

To spot a bear trap, investors can look for certain warning signs and indicators on a stock chart. For example, a bear trap pattern may be signaled by a break in the upward trend, such as a sudden and sharp decrease in prices that breaks through a key support level or moving average. This can indicate that the bulls are losing control and that the stock is starting to attract selling interest.

Another sign of a potential bear trap is a divergence between the stock price and other indicators, such as the relative strength index (RSI) or moving average convergence divergence (MACD). For instance, if the stock price continues to trend downward while the RSI or MACD shows a bullish divergence (i.e., moving higher), this can indicate that the bears are losing momentum and that the stock may be ready to reverse course.

In addition to chart patterns and technical indicators, investors can also look for fundamental signals that may indicate a bear trap. For example, a bear trap pattern may be signaled by a positive earnings report or news of a significant acquisition, which can cause investors to reassess their bearish bets and start buying, leading to a sudden and sharp reversal in prices.

In a nutshell, spotting a bear trap in the stock market requires a combination of technical analysis, fundamental analysis, and market knowledge. You have to backtest whichever of the combinations you have chosen well using price data so that you are armed with a statistically proven edge that outsmarts the traps when next you see them.

Bear Trap in Chart – Example

The above chart is an example of a bear trap. We could see a significant lower trendline acting as a support line broken by price to the downside.

Impatient retail traders would have shorted the point highlighted in blue, and just as they are into the position, their stops are triggered, and they are out of the way. The market returned to its uptrend as if nothing had happened.

On the other hand, should one have followed the guide we had explained on how to spot these traps, the trader could have easily spotted the divergence between the price and the MACD showing that the reversal will not take place just yet and avoid shorting AAPL stock.

Why Does a Bear Trap Happen?

This false signal can cause retail traders (individual investors) to sell their positions, only to see the price recover shortly after that. This can be a costly mistake for retail traders, as they may end up selling their positions at a loss.

One of the critical factors that can contribute to a bear trap is the presence of market manipulators (Also known as Market makers or liquidity providers). These individuals or groups use various tactics to manipulate the price of a security for their gain. One common tactic is to create a large volume of sell orders at a specific price, which can cause the price to drop rapidly. This can trigger a downward spiral as other investors see the falling price and decide to sell their positions.

However, once these market manipulators have sold their positions, they may start buying up the security again at a lower price. This can cause the price to recover, leaving the retail traders who sold their positions at a loss. This is the essence of a bear trap – a situation where retail traders are misled into selling their positions, only to see the price recover shortly after that.

Another factor that can contribute to a bear trap is the use of stop-loss orders by retail traders. A stop-loss order is an instruction to sell a security when it reaches a specific price automatically. This might be a valuable tool for retail traders, as it allows them to limit their losses in case the price of the security drops unexpectedly. We recommend backtesting your strategy and implementing a stop-loss. Most likely, you find out that a stop-loss makes the strategy perform worse. There is no best stop loss strategy.

However, if the market is experiencing a bear trap, the use of stop-loss orders can exacerbate the situation. As the price drops, a large number of stop-loss orders may be triggered, causing the price to drop even further. This can create a feedback loop, where the falling price leads to more stop-loss orders, which in turn causes the price to drop further.

How Does a Bear Trap Affect Retail Traders?

We have seen why we have bear traps in the market. They were intentionally laid for the retail traders by the liquidity providers. We know that they have huge orders to execute at a specified price level which they usually set above the stop loss of the typical retail trader.

Why above the stop losses? Simple. The market is a zero-sum game. For a successful buy to take place, someone must be willing to sell at the same price. So, these market makers entice retail traders to sell on impulse; at this time, their stop losses represent buy orders in the market. When there are enough buy orders, the market makers run prices up again to buy at a discount from the retail trader, who, at this point, has no other choice.

Retail traders fall victim to these traps primarily due to cognitive mistakes and biases. The average retail trader is impulsive, and FOMO influences him to jump right into a sell, but at the wrong time. Unsurprisingly, the market manipulators anticipated this and planned his trap accordingly.

How to Avoid a Bear Trap

So, how can retail traders protect themselves from bear traps? One of the critical things to remember is to avoid making investment decisions based solely on the price of a security. Instead, retail traders should consider other factors, such as the underlying fundamentals of the company, the broader market conditions, and any potential risks or uncertainties. By taking a more holistic approach to their investment decisions, retail traders can avoid getting caught in a bear trap.

In addition, retail traders should be wary of market manipulators and avoid following the crowd. It can be tempting to sell a security when the price drops, but this can be a costly mistake if the downward trend is only temporary. Instead, retail traders should stay disciplined and stick to their investment strategy, even in market volatility.

A bear trap can be a costly mistake for retail traders. By understanding how bear traps can occur and taking a disciplined approach to investment decisions, retail traders can avoid getting caught in one.

Frequently Asked Questions on the Bear Trap Trading Strategy

Here are a few of the questions you might have on your mind and quick answers to them:

  1. Is a Bear Trap Bullish or Bearish?

A Bear Trap is a bullish trading pattern. It is characterized by a sudden drop in price that tricks traders into thinking a downtrend is continuing when the price will soon reverse and rise.

  1. How Often Does a Bear Trap Happen?

The frequency of Bear Traps can vary depending on market conditions and other factors. However, they are not uncommon in financial markets, especially among more volatile assets.

  1. Which Indicator is Best For Bear Trap?

There is no one-size-fits-all indicator for identifying Bear Traps. However, some traders find that using a combination of technical indicators, such as moving averages, MACD and volume, can help them spot potential Bear Traps and make informed trading decisions. It is important to remember that no indicator is perfect and should be used as part of a broader, carefully considered trading strategy—backtest which works well for you and stick to it.

Bear trap trading strategy backtest

Mean reversion trading strategies have worked very well since derivatives trading kicked in in the early 1980s. This means that bear traps happen frequently. Traders use stop losses, and many at the most unfortunate moments.

Below is an example of a possible bear trap: The price breaks below the trendline, and many might get tempted to short:

However, in the stock market, there are plenty of bear traps. The reason is simple: stocks and bonds have a “tailwind” and have proven to rise over time if you have patience. Thus, you might get fooled into many bear traps, especially when stop losses are hit.

Trading Rules

In our trading strategy shop, trading strategy #1 takes advantage of the bear trap. It buys on breakdowns and sells on strength.

If we use the trading rules on QQQ, we get the following equity curve:

There are relatively few trades (181) but the average gain per trade is 1.7%, CAGR is 13% over the period (7.5% since 2010), and the win rate is 80%. You are only invested 10% of the time, thus the capital can accrue interest or be used for other trading strategies 90% of the time. Max drawdown is a modest 20%.

If you are willing to risk more, this is how it has performed on QLD (QQQ with 2x leverage) since 2010:

The number of trades is 103, the average gain is 1.8%, CAGR is 13.5%, and max drawdown is 21%. However, using leverage can always backfire (big time).

The Bottom Line

Understanding this topic will mean some saved dollars to you down the years as an investor. Hence, you need to master it truly.

Mastering the topic will also imply mastering yourself in the market and cautioning yourself against FOMO because no trap can force you into the market without your consent.

Here’s what we covered in this article in brief: In the trading world, there are institutions with deep pockets whose orders are large enough to manipulate the market, and they often do. One of the tools they use is the bear trap to collect buy orders in the form of the stop losses of bearish retail investors.

We also went through how to spot these traps by using other technical indicators, such as the MACD, to filter out signals that could have parted our money from us.

Finally, we saw how we could avoid the traps by controlling what is in our control: our execution. A trade executed in fear of missing out is half lost. Backtest and stick to what works for you.

Here you can find all our Trend reversal trading strategies.

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