Bear Trap – Best Strategies to Profit from Short Squeezes

Bear Trap – Best Strategiesto Profit from Short SqueezesHave you ever felt the devastating market force of a beartrap? The all but certain bullish trend stops abruptly and atrend reversal begins. Then you say, “Hey, let’s catch thatdrop!” and you short-sell the equity. Suddenly, the price doesa rapid jump contrary to your trade! What a shame! Have youever felt that? I bet you have. This is what traders call “TheBear Trap”. In this article, we will cover the inner workingsof a bear trap and how to avoid falling into one.

Bear Trap DefinitionA bear trap occurs when shorts take on a position when a stockis breaking down, only to have the stock reverse and shoothigher. This counter move produces a trap and often leads tosharp rallies.

Bear Trap SetupThe bear trap chart pattern is a very basic setup. You willwant a recent range to be broken to the downside withpreferably high volume. The stock will need to get back abovesupport within 5 candlestick bars, then explode out of the topof the range. The last component of the setup is that thestock should have a decent price range. A wide price range iscritical, as it increases the odds that the stock will haveroom to trend in order to book quick profits.

Why do Bear Traps produce sharprallies?The first wave of buying will occur when the most recent swing

high is exceeded, due to the number of shorter term traderswho have their stops slightly above the most recent swinghigh. The second wave of buying comes into play once thestrong shorts realize that this is not just a dead cat bounce,but that the move has legs. This will produce the secondbounce, which will often precede the short-term top in thecounter move.

Bear Trap Chart ExampleBelow is an example of a bear trap on 7/6 for the stockAgrium, Inc. (AGU). You will notice that the stock broke tofresh two-day lows, before having a sharp counter move higher.

Bear Trap

How to Avoid Bear TrapsYou will encounter many bear traps during your trading career.As we stated earlier, the key is not to fall into one. As youprobably guess, it is impossible to avoid every bear trap;telltale signs you can lookout for in order to avoid theselosing trades.

Volume IndicatorMarket volume is one of the most important components foridentifying bear traps. When a stock is starting to reverse,approaching new highs or new lows, you will notice volumebeginning to accelerate.

However, what if the market changes direction and the volumeis low? Watch out! This could be a bear trap!

Bear Traps and Volume

This is the 10-minute chart of Twitter from Aug 26 – 27, 2015.The long black arrow defines the bullish trend. Suddenly, thetrend line is broken and the price begins to decrease sharply,which is highlighted in the red circle. At the same time,volume is relatively low, which is a sign that the reversal issuspect at best.

So, is this a true reversal, or a bear trap?

Bear Traps and Volume 2

After the break in trend, Twitter forms a base and thenrallies back up to the recent peak.

Later, Twitter breaks the lower level of the blue triangle,thus giving the impression that the resistance area is toostrong to be broken. However, the break through the trianglehappens during low volumes like the previous break of theuptrend line. We have a second suspicious bearish breakout.Now what?

Bear Traps and Volume 3

If you had shorted after the trend break or the trianglebreakdown, you would have gotten yourself into a bear trap!Notice that the real stock moves occur during high volumes.These high volumes were absent during the two breakdowns,hence a bear trap developed.

Fibonacci LevelsFibonacci ratios are crucial for identifying trend reversals.If the price doesn’t break key Fibonacci levels, you shouldassume the price reversal is in question. These sort of minorbreaks should be perceived as trend corrections, but not truebreakdowns.

Let’s now see how Fibonacci fits within the bearish trapscenario with Twitter.

Bear Traps and Fibonacci Levels

Notice that after the trend interruption, Twitter finds strongsupport at the 23.6% Fibonacci Level. The next bottoms are noteven close to this level. In our case, the price just bouncesin the blue resistance. Then, the new rally appears.

Just as a rule of thumb, if a stock is unable to retrace 38.2%of the move, the primary trend is strong.

DivergenceIf you trade with indicators, which give you divergencesignals, then you can easily spot bear traps. If the pricebreaks downwards, but the indicators account for a bullishundertone, then we should suspect the bearish move is likely atrap. It is not that important which indicator you use. It isimportant that this indicator provides divergence signals. In

the image below, I will show you how to spot bear traps withthe relative strength index and MACD.

Bear Traps and Divergences

This is the 10-minute chart of Bank of America from Nov 12 –16, 2015. The blue lines indicate a trading range, which BACwas stuck in for the majority of the day. The red circle showsthe breakdown in the blue channel. The blue lines indicate thedivergence between the price and the two oscillators. The redline on the chart shows that the price is making lower lows,while at the same time the MACD and RSI are clearly movingupwards. This creates two bullish divergences between theprice and the two indicators, despite the bearish breakout.This is a sign that a short position would not be a good movein this case. Let’s now see how the trade actually developed.

Bear Traps and Two Divergences

After the bearish breakout, the price starts a steadyincrease. This means that our breakout was indeed a bear trap.Fortunately, we managed to avoid the bear trap by spotting twodivergences between price, RSI and the MACD.

Price ActionHere we are again discussing the most important stock tradingcomponent = the price action!

If the price action were screaming a bearish trend is comingto an end, would you go short? Not me!

Have a look at the example below:

Bear Trap and Falling Wedges

If your first thought was that you have seen this chartbefore, then you are right. This is the same Agrium Inc. chartwe discussed at the beginning of the article. The new thing isthe orange lines, which create a clear falling wedgeformation. As you probably know, falling wedges after bearishtrends lead to trend reversals. Thus, we expect the price tobreak through the upper level of the formation.

In our case, though, the price breaks through the lower levelof the falling wedge figure we stay out of the market avoidingthe bear trap.

When the price gets back to normal and breaks the upper levelof the wedge, there is even a long position opportunity.

Let’s now go through another bear trap example, which we canavoid with simple price action knowledge:

Bear Trap and Price Action Trading

This is the 30-minute chart of Google for the period Dec 9 –17, 2015. This is another example of a bear trap stock chart,which could be easily recognized with simple price actiontechniques.

First, we have a falling wedge figure, which is outlined withthe blue lines on the picture. We expect the price to breakthe falling wedge upwards, switching to bullish direction.Yet, Google breaks the falling wedge in a bearish direction,

against the simple price action logic.

Even if we are lured into a short position here, we have asecond chance to act wisely and to close the trade on time,when a hammer shows up four candles later. This is a famousreversal candle pattern, which signals an upcoming priceincrease. If we close our short position after this bullishsignal, we will not only avoid big losses, we would also havegenerated a profit equal to $2.50 per share!

Note that this is not a good practice at all. Do not attemptto trade a reverse bear trap on purpose. If you get yourselfinto a bad trade, try to play your odds as best as possible inorder to get out of the market unscathed.

How to Protest Yourself Against Bear Traps

The answer to this question is ridiculously simple and you canfind it in every bear trap book – use stop loss orders!

If you enter a bear trap and you have an active stop lossorder, what does this mean? This means that worst-casescenario you will lose no more than what you have planned tolose. Thus, your bear trap trade will not bankrupt you.

ConclusionIt is called a bear trap, because this chart patternoften lures traders into short positions only to quicklyreverse to the upside.Bear traps could sometimes be identified and avoided.Some of the tools, which help us against bear traps are:Volume Indicator – low volumes represent moveuncertainty.Fibonacci Levels – price tends to bounce from crucialFibonacci levels.Divergence Tools (like Oscillators) – Bullishdivergences imply upward price move.

Price Action – patterns could often contradict tobearish breakouts.If you find some of these four signs during bearishbreakouts, this could be a bear trap.Spotting bear traps help us avoid them.Bear traps could easily be hedged simply by putting stoploss orders on your trades.The opposite equivalent of bear traps are the bulltraps.Bull traps act the same way as bear traps but in theopposite direction.