He wants to convince the market participants about the price correction, but the bear traps are organized by those with large shares in order to make a quick profit.
What is a bear trap?
More often than not, novice traders get caught up in price volatility when trading stocks, commodities, bonds or even cryptocurrencies.
While it is advisable to invest for the long term to avoid such bouts of volatility, price reversals can confuse even the most experienced traders. For this reason, it is important to spot the signs of a false reversal in time, the momentary change in the direction of the exchange rate, before resetting the basic trend, in order to avoid falling victim.
Increased volatility can even lead short-term traders to take multiple trades, which in most cases will result in heavy losses and affect their confidence in the underlying asset.
In a bull market, a sudden downward movement in prices can induce increased volatility and force market participants to either liquidate their long investments or short the underlying asset in hopes of making a quick buck. This reversal, if a group of investors sells in large volumes, may be temporary and last only as long as it takes to buy back their holdings at a lower price.
Called a bear trap, this form of market manipulation tricks bear participants into believing that a price reversal signals the beginning of a downtrend, often followed by a sharp resumption of the previous uptrend.
Short selling, the practice of selling an asset to later buy it back at a lower price, is highly speculative during such periods of volatility and causes bear traders to assume extreme risk. Because bear traps are often sudden and short-lived, even long-term investors can succumb to temporary selling pressure and lose some or all of their gains.
How does a bear trap work in crypto markets?
It is used to describe both a mechanism and a short-term price reversal, falsely indicating the beginning of a downtrend. In crypto markets, a bear trap is a form of market manipulation caused by the concerted efforts of a group of traders who hold large amounts of a particular cryptocurrency.
By coordinating with each other, the collective selling of a particular token causes the price to fall, leading other retailers to believe that the uptrend is over. As a result, many investors may sell their holdings, resulting in a further drop in the price for a few hours or the end of the day.
Usually, when they fall below previously held lows, these powerful trading groups buy back the volumes they sold at depressed prices, triggering a sharp upward move that closes bearish bets en masse.
Traders with short positions would look to buy the cryptocurrency to limit their losses, and the resulting buying momentum would only serve to drive the price even higher. Thus, the trader group or bear trap setters want to profit from the difference by selling at a higher price and buying back all sold positions at a lower price level without affecting the amount of cryptocurrency they hold in the long term.
Bears versus short sales
Like stocks, popular cryptocurrencies like Bitcoin can be shorted using various mechanisms. Examples include short-selling tokens, margin trading or trading futures and underlying cryptocurrency options. These avenues are often used by mature traders and institutional investors to hedge their positions in the secondary market and protect their investments in the event of a market or trend reversal.
Short selling a cryptocurrency is a common practice, but at a volume that is a fraction of the primary token's trading volume. However, if done on an extremely large scale, for a cryptocurrency like BTC, short selling can put massive downward pressure on its price due to a collective rise in the fear quotient.
Technical indicators such as the Relative Strength Index (RSI) can indicate an entry into bearish territory for a cryptocurrency, which can then trigger a broader sell-off by less informed retail investors who are risk averse. If this sentiment persists and prices fall below key support levels, it could attract even more bearish investors to go short as a profitable opportunity for large trading units, creating a bear trap by covering their original short positions.
Thus, a bear trap is usually preceded by the shorting of a cryptocurrency by several investors with large token reserves and ends when they close out their derivative positions or buy back their shorted crypto positions, or a combination of the two.
Is the bear trap bullish or bearish?
In the strictest sense, a bear trap unsettles traders and market participants as the underlying asset undergoes a change in momentum against the primary bullish trend before quickly reversing again to resume its upward trajectory.
If the price of the asset then breaks above the recent resistance level, it can be a positive sign and can be interpreted as a buy signal by a bullish trader. Alternatively, those with a bullish stance can use a strategy that involves simultaneously selling calls and entering key price levels to profit over a wide range of prices.
In the case of a bearish trader, the first trend reversal can be interpreted as a sign of selling, which requires a thorough risk-profit analysis and extreme caution to avoid capital loss. The entry point to take a short position must be timed perfectly and this makes bear trap trading very difficult for a bear trader.
Any mistake made in recognizing the resumption of an underlying bullish trend can be disastrous for bearish positions, especially if they are shorted or leveraged.
How to identify and avoid a bear trap?
In most cases, identifying a bear trap requires the use of trading indicators and technical analysis tools. These indicators are likely to confirm whether the trend reversal following a consistent upward price movement is real or just short selling.
Any downtrend should be driven by high trading volume to rule out the possibility of setting up a bear trap. In general, a combination of factors such as price retracement slightly below a key support level, failure to close below a critical Fibonacci level, and low volume are signs of a bear trap.
For crypto investors seeking low risk, it is best to avoid trading during sudden and unfounded price reversals unless price and volume moves confirm a trend reversal below an important support level.
It is advisable to hold cryptocurrencies at such times and avoid selling unless the prices have exceeded the initial purchase price or the stop loss level. It is useful to understand how cryptocurrencies and the entire crypto market react to news, sentiment or even crowd psychology.
Practicing this can be a lot harder than it looks, especially when one of the factors is the high volatility associated with most cryptocurrencies in day-to-day trading.
On the other hand, if you want to profit from the reversal of momentum, it is better to enter into a put option rather than a short sale or become a long-term investor in the given cryptocurrency. This is because short selling can expose the trader to unlimited risk if the cryptocurrency goes up again, which is not the case if one takes a short position.
In the latter strategy, losses are limited to the premium paid and have no effect on previous long crypto positions. Long-term investors seeking profit without high risks are better off staying away from trading altogether during a bear trap.
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