Warrior Trading Blog

Bear Trap Explained For Beginners

bear trap

What is a Bear Trap?

Bear traps most often occur in strongly trending stocks.

A bearish catalyst, usually supported by bearish short-term price action, suggests that a trend reversal is imminent, prompting bears to put on large short positions at precisely the worst time.

The stock then continues to the upside, forcing many of the shorts to cover.

The short-covering makes the situation all the direr for the holdouts who held onto their shorts, typically forcing them to cover near the top of the rally. 

The most extreme bear traps involve “cult” stocks, where both sides of the trade are highly impassioned about their thesis.

Usually, the price is parabolic, and the fundamentals arguably don’t support the current valuation, at least in the eyes of value-minded shorts.

You can divide these types of extreme situations into two kinds of stocks: hot growth stocks (think Tesla, Square, etc.) and your flavor-of-the-week parabolic low-float stocks. 

You typically don’t see substantial bear traps occur within standard intraday continuation patterns on a dull stock like Johnson & Johnson (JNJ).

Bear Trap Example

The best way to explain what a bear trap is through the story of Tesla’s (TSLA) stock, which is probably the best known “story stock” in the past generation.

The company has attracted impassioned supporters and detractors staking large portions of their wealth on the trade.

Without the fanfare of Elon Musk and fancy marketing, Tesla would be a regular car manufacturer to most–one which is producing expensive cars in a new and uncertain industry.

Just look to the legacy automakers like General Motors (GM) and Ford (F), who trade at $58B and $35B, respectively, compared to Tesla’s behemoth $630B market cap.

This is the argument of the shorts.

Some of the most well-respected short sellers like Jim Chanos and David Einhorn are ardent Teslas bears. They have complaints about accounting, financial viability, and valuation.

As such, as Tesla went from a small niche company to the dominator it is today, shorts took every bearish catalyst as a reason to add more to their position.

And at each point until today, their positions have been decimated. Like it or not, Tesla has become a bear trap machine. 

Take this chart from SeekingAlpha’s Arun Chopra, which displays just a few of the short squeezes in the stock: 

 

How To Avoid a Bear Trap

Bears get into bad trades every day, and not everything is a bear trap.

A bear trap is the culmination of several avoidable factors that can you leave ruined on the short side.

A bear typically loses multiple times their average risk per trade in a bear trap.

Practice Disciplined Risk Management

Risk management is the number one factor in protecting your trading account from any trade.

If you plan and manage both your position size, stop loss, and risk per trade, it’s hard for any trade, bear trap or not, to cripple you.

As a short seller, you’re going to get caught in some bad spots.

We all know this when we click that “sell short” button on our brokerage platforms, so plan ahead. Aside from setting a stop loss, we need to have a rational risk per trade. Even the best traders only win 60% of the time, so you should expect to lose very often.

As such, a rational risk per trade, measured as a percentage of your account is required. 

According to Van Tharp, a top trading coach and author of several books on trader performance, position sizing, and your average risk per trade is the second most crucial aspect of trader success behind psychology.

He refers to a study performed by Brinson, Singer & Beebower in 1991 (Financial Analysts Journal), which analyzed 82 pension fund managers’ performance over 10 years.

The study found that position sizing, rather than asset allocation, accounts for 91% of performance variability.

In other words, most of their performance can be attributed to how they sized their positions rather than which positions they owned at any time. 

In his own exercises with traders, he’s found the “sweet spot” to risk on any trade is roughly 1.5% of your trading account. This number can, of course vary, depending on your account size and aggression level.

Author of The Art and Science of Technical Analysis, Adam Grimes, thinks risking 5% of your account per trade is the most aggressive a trader should go. 

Most traders in bear traps freeze.

They reach their max loss on that position and don’t have a stop loss. Instead of cutting their losses and exiting, they try to “win back” some of their losses tactically.

And because several other bears are stuck in the position as well, the stock usually continues rallying, only making their losses worse. 

The best course of action here is to exit as soon as you reach your max loss size.

You can always re-enter at a later point. Every minute you don’t cover your short, you’re making a conscious decision to short the stock.

Think about it this way: if you weren’t already in the position, would you establish a short position here?

If not, close the trade and wait for the next opportunity. If you don’t lose all of your chips, you can continue playing another day, which is the most important thing. 

Don’t Ignore the Big Picture Technical Pattern

Trapped traders, long or short, are there for several reasons.

They’re not disciplined risk managers, they’re falling victim to the loss aversion fallacy, and they’re usually missing some key technical factors which would suggest they might get trapped. 

Let’s take an example of a parabolic low-float stock. The company is NaturalShrimp, an OTC “aqua-tech” firm that is supposed to have a cool method for producing quality shrimp.

 

The conventional wisdom here is to short the first red day on a stock like this.

The theory essentially states that these companies are pumped by insiders and email newsletters and fold under any pressure. At this point, the insiders have already sold, leaving only bagholders.

This is a very valid method of trading in which countless people make a living trading.

As such, these can form the deadliest bear traps when things don’t go according to plan for short-sellers.

There’s an old trading quote I heard from Peter To that goes, “the best trades have three phases: innovators, imitators… and idiots,” and it definitely applies to beginning bears who try to short any low-float pop without regard.

While we benefit from hindsight, we can see that the first red day for $SHMP on December 16 was a doji candle–not exactly a decisive plummet. Looking at the intraday action on that day, we’re given a clue.

 

Price rejection at the open. A string of red candles 2x the average range. Most bears probably think that it’s time for this stock to tank. Hard to blame someone for getting short early on in the day.

But the tone of the price action changed. The stock rallied off the lows and closed near its opening price.

This intraday action should give bears some new information.

There was enough intraday demand following a decline to at least prevent a waterfall. This is relatively abnormal for most stocks of this nature, so it’s worth at least reducing your size into the close. 

The next day tells a similar story. Now we have two data points. The stock found short-term support that at least delays what many view as the inevitable plummet of such a stock.

 

Again, we know that $SHMP continued to rally because we benefit from hindsight, increasing nearly 40% from the December 17 close.

It became quite clear that this stock isn’t acting strictly within the template of a low-float pump and dump after two days of timid selling.

If you are familiar with how these stocks trade, they typically tank, and most traders regret not organizing a locate with their broker. 

Don’t Short Into Upside Momentum

Markets go through periods of range expansion and range contraction.

Most stocks remain in a period of range contraction–not doing a whole lot–most of the time. Bear traps are events on the range expansion spectrum’s far-end, however, and occur at the least expected times. 

When a market’s range is expanding, there’s typically one side of the trade that is “in control.” Usually, this is pretty easy to see. 

For example, real estate assets manager St. Joe (JOE) recently went into a significant range expansion phase after a long period of range contraction. It’s clear that the bulls are in control. Rallies are strong and undisputed, and pullbacks are very shallow and timid.

 

One of the most prominent mistake short sellers make is losing sight of where the significant energy is flowing. In a stock like $JOE, it’s clear the bulls are in control, and the energy is flowing that way.

Trying to short a stock like this right now is asking for trouble. 

The most common way traders get trapped in these sorts of stocks is trying to short a new bout of momentum.

Consider the below chart:

 

There’s a tendency to want to fade these large moves, especially on the first red day.

This is typically a bad idea.

These big momentum moves are indicative that there’s significant demand for the stock and that large buyers are making moves.

Because it takes institutional buyers several days to weeks to establish their full-sized position, they are likely to take advantage of any dip-buying opportunities.

This isn’t to say that stocks receiving new institutional sponsorship are infallible; they fall like rocks all the time. It’s just one extra edge in our favor. 

Don’t Try to Be Early

Market Wizard Mark Minervini is fond of saying, “it’s not about getting the lowest price; it’s about getting the right price.”

It’s much easier to know if you’re wrong when you wait for confirmation to establish a trade.

Consider the below example in Macy’s (M) stock:

 

The stock has retreated from its highs but is still barely holding an uptrend pattern. Rather than preemptively getting short and possibly riding the stock back up to a new high, it’s much easier to know where your trade stands if you wait for it to break its uptrend pattern.

I’d rather short closer than $10 than try to “cheat” and get short at $10.50 while the stock is still technically in an uptrend.

This way, I could set a stop loss at roughly $11 and play for the next swing low. Trade success is pretty binary because if the market tests a new low and experiences price rejection, I know that the uptrend pattern is likely to continue holding and become a “complex pullback.”

At this point, I can exit the trade and reduce the complications. 

Bottom Line

All of us get trapped in trades. We might think we’re onto something the rest of the market is missing, only for the market to dunk on us.

Nobody can avoid this fate sometimes, and there’s nothing to be ashamed of. The difference is how we react to getting trapped in a runaway trade. 

Even if the stock gaps up and skips our stop loss, we’re still in control of our reaction. We can either admit that we made a bad trade, quickly exit and lick our wounds, or we can try to test the fate of our accounts and “trade around” our position.

This is usually because we don’t want to admit defeat. These are the types of situations that turn a 2% account hit into a 10% account hit.