In volatile crypto markets, traders must contend with many challenges. One of the most common is the bear and bull trap, which can quickly catch traders off-guard if they aren’t careful. In this FXOpen article, we’ll explore how these traps work, provide examples to illustrate their characteristics, and tell about practical ways to avoid them.
What Is a Bear Trap in Crypto?
In cryptocurrency trading, a bear trap is a signal indicating that a crypto asset is declining, luring in short sellers to position themselves for a price drop. However, this signal is false; after reaching a new low, the asset rebounds sharply. On a chart, this may look like a breakout below a support level, then a quick reversal, usually leaving a long wick.
The term ‘bear trap’ comes from the way it ‘traps’ bearish traders. They are almost instantly at a loss and psychologically vulnerable – they have to either realise a loss or risk further losses by holding their position.
Typically, covering these shorts (i.e. closing the short by buying back the position) fuels the bear trap, driving prices higher as traders rush to get out of the market to avoid further pain. It’s also worth noting that long traders expecting the reversal are also often stopped out during a bear trap – after all, it’s commonly repeated advice to set stop-losses beyond a support or resistance level.
It's essential to understand that bear traps are primarily psychological. They often occur when market sentiment is overwhelmingly negative, with traders expecting further price decreases. Institutional players in the market use this negativity to their advantage. They take long positions and briefly push prices down to trap many short traders and trigger long stop-losses. When shorts begin covering, and other traders start to buy, prices rise and put these players in profit.
In the example above, we see Bitcoin dropping heavily on the left, continuing a larger downtrend off-screen. Price finds a bottom, creating an area of support that is held throughout the day. It’s reasonable to expect lower prices, given that BTC has been in a long downtrend.
As a result, when the price begins to break down with a sizable candle, breakout traders begin entering short positions. Those who took a long position, anticipating a broader trend reversal, are stopped out.
When the price begins to reverse as buying pressure picks up, short traders are trapped, likely at a small loss; stopped-out long traders are looking for a re-entry. As shorts began closing their positions and long traders rushed to enter again, Bitcoin surged higher.
What Is a Bull Trap in Crypto?
A bull trap is effectively the opposite of a bear trap: prices rise, encouraging traders to buy a cryptocurrency. It makes a new high and shortly reverses, putting traders who bought the breakout at a loss. This is the primary difference between a bull trap vs a bear trap.
Likewise, bull traps are all about emotion. Bulls are trapped, realising that they will likely take a loss. Bears that are correct in predicting an impending downtrend are stopped out and look for another entry. The fear and frustration of both types of traders add selling pressure to the market, driving prices lower.
In the chart above, Bitcoin drops after an extended uptrend off-screen. It forms a low, retraces, and reacts at an area of resistance. Price continues higher, breaking through the resistance and forming a long wick. Traders buying the breakout see their position move to a loss as the long wick forms, while many short traders’ stops are triggered.
As it moves lower, a bear trap on the lower timeframe forces prices higher once more to form the real bull trap. Breakout traders think it’s for real this time as the high is broken and open long positions, while some short traders that found a reentry are stopped out again. When the price begins to decline sharply, the realisation of the market’s true direction forces the price even lower as traders pile in short.
This example is interesting in that it demonstrates that bull traps can occur repeatedly in the same area. While we won’t cover it in this article, learning the Wyckoff methodology can help you deal with and understand why you may see multiple bear and bull traps in a given area.
Want to mark up charts like we’ve done here? Head over to FXOpen’s free TickTrader platform, where you’ll find each of the tools used to create the examples in this article.
How to Avoid Bear and Bull Traps
It can be tricky to avoid falling into bear and bull traps in crypto, meaning traders should take precautionary steps to prevent frustration and potential losses. Here are four ways that may help traders sidestep these traps.
Understand Where Liquidity Lies
Bear and bull traps serve two purposes: to play on the emotions of traders and to tap into liquidity. Liquidity allows traders to take large positions without significantly affecting an asset’s price, reducing slippage/transaction costs. The deepest areas of liquidity are often found just beyond support or resistance levels, where stop losses are placed, and breakout traders are waiting and are usually tapped into before a considerable move occurs (as seen in the examples).
Liquidity builds up in areas with roughly equal highs and lows, along seemingly-strong trendlines, and at round numbers (e.g. $24,000), but is also present beyond every key high and low. In setups where the obvious place to set a stop-loss is one of these areas, you can consider using a wider stop-loss. Beyond the next significant support/resistance level is a good place to start.
Trade With the Trend
The phrase 'trend is your friend' is popular among traders for a reason. More often than not, these traps push the price in the direction of the broader trend. Understanding this can help avoid such traps. If the broader market trend is clearly bearish, for example, traders might want to reconsider taking a long position based on a potential breakout. Similarly, if the trend is bullish, it might be wiser to hold off on initiating short positions. This doesn't mean that counter-trend opportunities should be completely ignored, but rather that they should be approached with caution.
Trading volume often provides valuable clues about market activity. A sudden price movement accompanied by high trading volume can indicate a genuine breakout, while low volume may suggest a trap. This isn’t always the case since bear and bull traps can generate significant volume themselves, so it’s worth comparing a recent breakout’s volume with a potential trap’s volume to gauge strength.
Lastly, traders can use the relative strength index (RSI), a popular momentum indicator, to find early warning signs of reversals where traps often occur. Divergences between the RSI and price suggest weakening momentum and the possibility of a bull/bear trap. For instance, if the price reaches a new high but RSI does not, a reversal could be due. Conversely, if the price makes a new low without the RSI confirming, it could be a sign of a potential bull trap.
The Bottom Line
In conclusion, bear and bull traps are just one of the many challenges traders face when navigating the crypto markets. Understanding how they work and how to avoid them can significantly reduce the losses a trader takes and may even present opportunities for profit if taken advantage of correctly.
In fact, these traps occur across all types of markets, not just crypto. If you want to put your newfound knowledge to the test across over 600 stock, forex, and commodities markets, you can open an FXOpen account. You’ll be able to take advantage of the advanced TickTrader platform, low-cost trading, and blazing-fast execution speeds. Good luck!
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