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Effective Tactics: Stop Falling Into Bear Traps
- What exactly is a bear trap in trading?
- Steps to avoid falling into bear traps.
It is critical for every trader to recognize a bear trap in the charts when it comes to conducting a technical analysis. Bear traps are technical patterns that show an incorrect reversal of a rising price trend. In other words, a bear trap is an inaccurate reversal indication of an uptrend from a downtrend that may lure in unaware investors.
Bear traps exist in all markets, including equities, futures, bonds and currencies. Indeed, a decline that makes investors open short sales is what usually triggers a bear trap. However, after opening a short position, the value of the asset stays flat or declines, resulting in investor losses.
Bullish traders typically sell a declining asset while bearish traders aim to short the asset. Both share the goal of buying it back once the price declines. If the downward trend doesn’t occur or is reversed after a certain period, the price reversal is identified as a bear trap.
The purpose of this article is to help investors identify a bear trap in the charts and how to avoid suffering losses from one.
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Check the Volume Indicator
One of the most important components when trying to identify a bear trap. Investors will often notice that when a reversal trend for a particular asset approaches new high and lows, the volume will accelerate. However, what happens when there’s a reversal in the markets and the volume is low? Possibly a bear trap.
Let’s say a particular asset is experiencing a bullish trend but suddenly starts experiencing a sharp decline while volume is low. This means that the reversal is suspicious, but then the price rallies back up to the recent peak. However, the price declines again suggesting that the resistance level is too strong to be broken. Nonetheless, if this happened with low volume again, this means that the reversal is still suspicious.
If an investor shorted after the trend break, he or she may fall in a bear trap. Remember that big movements in an asset’s price happen when there are big volumes. Conversely in the example above, the volume is always low.
Pay Attention to Fibonacci Levels
Fibonacci Levels are indicators that connect two points (usually a high and low point) that a trader sees as relevant. In addition, Fibonacci Levels use horizontal lines to indicate where support and resistance are in the charts. For example, if the price of an asset is $10 but then drops $2.36. The retraced 23.6% is a Fibonacci number. This percentage area will then identify where the price may stall or reverse.
Now, if the price reversal didn’t exceed a key Fibonacci level (23.6%, 38.2%, 50%, 61.8% and 78.6%). The trend reversal it’s once again suspicious and traders could be dealing with a bear trap.
Open a Larger Stop-Loss Order
It’s evident that placing a stop-loss order won’t stop the bear trap from forming in the charts. However, since the stop-loss is a large distance away, the trader bets on the fact that there is a bear trap present.
Sometimes a long time can pass before the price can turn around and decline. Moreover, the price may not return at all which means that the order will be executed after a long wait. It’s important to keep in mind that the trader opened a stop-loss order so losses could be kept at a minimum. It’s also important to trade smart in instances where a bear trap is suspected.
Trade the Retracement. Avoid Trading the Initial Breakout
Ultimately, it all boils down to common sense. If a trader is planning to sell an asset at any given price, then the smart approach would be to sell after the breakout happens. After the price goes down, confirming that the downtrend is still solid, then the trader should wait for the retracement and then execute a sell order.
Many expert traders and investors have their own tactics and best practices to identify or deal with bear traps. Furthermore, novice traders should consider these initial points before engaging with the market when they are suspecting a trap in the making. The primary objective for new traders should be to gain experience and knowledge while risking the smallest amount of capital possible.