What Is a Bear Trap?
A bear trap, which typically is a precursor to a short squeeze, occurs when coordinated action among investors results in a drop in the value of an asset. This type of situation can develop with stocks and bonds, and is very common with cryptocurrency investments.
A bear trap can result in significant financial loss for both novice and experienced investors. Investors may be tempted to sell short, potentially losing money because of pricing volatility. Often, these investors will make multiple cryptocurrency transactions within a relatively short period of time as they attempt to time the market. Savvy investors, however, may be aware that the price dip will be short-lived, and they may continue holding the asset for a long-term gain.
The investors who initiated the bear trap, causing the price dip, might wait a while for the price to bottom out before buying at a low price and positioning themselves for substantial gains.
How Does a Bear Trap Work?
A bear trap is a type of price manipulation. Generally, a group of investors with considerable holdings will sell their cryptocurrencies in unison. An asset with a generally upward-trending price may suddenly drop in value. This leads some investors to believe that there is a trend reversal, and that they should sell before they lose a substantial amount of money. This causes the price to drop even further. Once the price hits a perceived bottom, the initial sellers of the asset once again purchase the asset at a much lower price. This causes the price to start rising.
The investors who sold the asset after the declining trend started, however, may not think about repurchasing the asset until the price increases again. In some cases, they may purchase it at a higher cost than what they sold it for, resulting in financial loss. Unfortunately, these investors often sell coins that may have otherwise been allocated for long-term holding. While they might experience a net loss, the investors who started the bearish trend may profit significantly.
Spotting a Bear Trap
A bear trap is generally caused by speculative investors who want to capitalize on the inexperience of other investors. Bear traps usually occur only with speculative assets, including cryptocurrencies. They are most common with assets that have prices in a strong upward trend. You may be able to spot a bear trap in action if you look at the trade volume. A significant uptick in activity that coincides with a steep, sudden decline in price could be a bear trap. Investors should analyze these factors closely before deciding to sell, or develop a plan for a long-term hold that buffers them against a bear trap loss.