Last week I was skiing in France with the family. Mrs R. and my eldest son have the risk-averse genes in our family, while I and the younger two boys got the ‘Hey, watch this!’ genes.
I decided it would be a great idea to hop over the back of a peak and drop down off piste. My eldest son looked at the terrain and didn’t like the idea of skiing below the big jagged rocks.
‘Those rocks have been there for thousands of years, they’re not about to fall on your head.’ I told him, brimming with confidence.
Unconvinced, he and his mother took the safe route down, while the intrepid 3 set off.
About a third of the way down the slope, my youngest son stopped for a breather. Meanwhile, some other skiers uphill had had the same great idea as us. They dislodged some rocks above us, and a jagged avocado-sized rock fell down the hill, hitting my youngest on the back of the head.
He was wearing a helmet, and was absolutely fine, but I was forced to admit that holiday risk-assessment is best left to my 14-year-old son.
The market is full of traps which can potentially hurt us. Traders need to walk a fine line between risk taking (otherwise we wouldn’t be in this game to start with), and risk management. If we don’t get caught out sometimes, it’s likely we’re not being aggressive enough. But when we do get caught, we need safety measures in place to minimize the damage.
Bear traps can be very nasty to get caught in.
They’re easy to see after the event – but much tougher to spot in live market action.
However, if you know how to spot them, and follow some simple rules in your trading, you should be able to not only dodge them, but use them to accelerate your profits.
Of course, sometimes we all get caught out, but if we have the right security in place, our false moves shouldn’t hurt too badly.
A bear trap is a chart formation that will usually crop up during an up trend, when the price has formed a support level, which it then falls below.
This breach of support alerts the sellers that the trend is broken and the market will now move lower. They’ll now take a short position now.
Very quickly however, the buyers get back in, forcing the price back up above support.
The sellers are now ‘trapped’ into a losing position.
Essentially, a bear trap is a false move below a support level. Fake moves can catch us all out, but there are some key factors to look for that can warn you this is a bear trap.
In the image above, we can see a trending market, which enters a consolidation period, with the price bouncing off an area of support a couple of times before that support fails and we have our bear trap. Almost immediately, the price rebounds, and we’re back into our up trend.
What’s a good thing to notice here is the volume indicator – we can see that as the dip down happens, there’s no surge in volume. This suggests to us that there’s no great sell-off going on here. It’s more likely some profit taking from long traders.
The volume also shows a spike on the following candle – this is a surge of volume as new buyers get back in on the pullback, and is a good sign that this breach down is not sustainable, and more likely a bear trap.
The image below shows the same bear trap, with the Stochastics indicator in place.
What we can see here is divergence: the price has moved lower, but the Stochastic has made a higher low. This indicates a lack of momentum behind the downward move …
… a warning of a bear trap.
The trick to play the bear trap is to catch the surge of momentum as buyers come back in and the market resumes its trend …
Watch for a rapid reversal after the breakout, within two or three candles – ideally with some momentum and volume behind it.
Of course, sometimes a bear trap will breakout with lots of momentum, lots of volume, and no apparent fundamentals behind it, and snap – the bears are trapped.
One of the best ways to avoid this situation is to be trading with the trend. Traders who get caught in a bear trap are usually trying to predict a market top.
Looking for turning points in the markets is a temptation, but remember that prices spend more time trending than turning – so if you’re looking for the turning points, the odds are stacked against you.
But bear traps can sometimes also happen within a down trend – when the price breaks below a downward channel and we see an opportunity to get into an accelerated down swing.
If we find ourselves caught in a bear trap, it’s best to exit fast, rather than wait for recent highs to be breached.
As with all trading, there’s no way to remove fake signals 100% – so we need good risk management in open positions so we can cut losses fast and quickly get out of danger.
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