Whenever cryptocurrency prices plummet, some traders see it as an opportunity to open positions designed to profit from downward market momentum. Products like put options and short perpetuals help them quickly adjust their strategies and make money even when cryptocurrencies enter stagnant or downtrending bearish phases. But not every dramatic price dip in the crypto market dooms digital assets to fall further.
Sometimes, traders believe there’s a trend reversal in a cryptocurrency’s chart, but they’re falling into a bear trap. If bearish traders get caught in one of these traps, there’s a good chance of getting trampled under a stampede of Bitcoin bulls.
Thankfully, you can use a few tips and technical indicators to assess whether you’re dealing with a genuine bearish pattern or a bear trap. In this comprehensive guide, we’ll review what bear traps are, why they’re so dangerous, and how to avoid falling into one.
What is a Bear Trap in Crypto?
A bear trap is a deceptive price decline for a cryptocurrency that makes it look like a coin or token is entering a sustained downtrend. In reality, however, the price fall during a bear trap is nothing more than a short-term dip in an overall bullish uptrend.
Bear traps are sometimes called false reversals because they suggest a cryptocurrency broke key support levels and is in the beginning stages of reversing from an upward trend to a bear market. The sharp price decline traps traders who expect the downward momentum to persist and try to profit from price declines with strategies like short-selling. As a cryptocurrency’s price recovers from its lows and starts moving upward, bearish traders typically close their positions at a loss, often triggering more buying pressure and further upside for the cryptocurrency.
How Does a Bear Trap Work?
Bear traps happen when enough traders sell a significant amount of their crypto holdings simultaneously, resulting in a price decline for the underlying cryptocurrency. In some instances, crypto traders collude to drive down the price of a digital asset, but not all bear traps are a deliberate form of market manipulation.
Whenever selling pressure temporarily exceeds demand in the crypto market, there’s the potential for a price dip and a bear trap scenario. One defining feature of a bear trap is it only happens when a cryptocurrency’s price is on a sustained rally.
Remember, bear traps have the power to fool you into believing a cryptocurrency is reversing from a bull to a bear market, so the virtual currency needs to be in bull market mode before a bear trap happens. If the cryptocurrency is already on a sustained downtrend, further downward moves would confirm the overall trend rather than signal a shift in the market momentum.
If enough traders believe a price dip is a genuine trend reversal, they open bearish positions such as selling call options or shorting a cryptocurrency on margin. In both scenarios, traders sell to open a position expecting to buy back the underlying cryptocurrency at a lower price to close their trades.
While these bear trap trading methods allow people to profit from price declines, they expose traders to potentially uncapped losses if a cryptocurrency’s price rises. When short sellers realize the price dip was a bear trap rather than a trend reversal, they often start buying back their short positions to cut their losses, which causes further upside for a crypto asset as buying pressure mounts (aka a short squeeze). The extra buying from shorts confirms the prior price dip was a temporary bear trap and contributes to a sharp price rally.
Identifying Bear Market Traps: Features to Consider
When cryptocurrency prices show signs of weakness, there’s usually a lot of fear, uncertainty, and doubt (aka FUD) in the news and on social media. While confirming a price dip is nothing more than a blip in the early stages is difficult, you can use a few indicators to assess whether a recent decline is a genuine trend reversal. Here are three metrics:
Average Crypto Market Volume
Volume measures how much a particular cryptocurrency exchanged hands during a trading session, symbolized as a bar graph on the bottom of a cryptocurrency’s price chart. You can use volume data to understand how active the cryptocurrency market is and how changes in activity correlate to a crypto asset’s market price.
In a bear trap, a mismatch between a cryptocurrency’s dramatic price decline and volume levels tends to occur. Although a cryptocurrency’s value falls significantly during a bear trap, you’ll often notice average or even below-average volume levels. Muted volume levels during a price correction typically suggest a small trader group driving a price decline rather than the broader crypto market.
Crypto News and Fundamentals
Another warning sign of a bear trap is if a cryptocurrency falls in value without news to support a price reversal. Bear traps often happen out of the blue and aren’t connected to major developments like network upgrades, policy changes, or security issues. In other words, when it comes to wondering why a cryptocurrency is suddenly dropping, it may be a bear trap.
Moving Average Trend Lines
When cryptocurrencies are in an uptrend, traders typically look toward moving average (MA) trendlines to identify critical support prices at the bottom of the cryptocurrency’s range. Typically, a cryptocurrency bounces from the top of multiple MAs while it’s in a bullish phase, but it remains below these trendlines during bear markets. Even if a cryptocurrency breaks below MAs during a selloff, traders often wait for the cryptocurrency to almost get back above these lines and fall again to confirm it’s a trend reversal rather than a bear trap. If a digital asset breaks through MAs but then jumps back up and starts bouncing off them again, it confirms the bull trend is still intact and the dip was an inconsequential deviation from the norm.
Bear Traps Versus Bull Traps: Spotting the Difference
A bear trap is a sudden drop in growing crypto prices, leading you to mistakenly believe that a sustained market decline is underway. However, the plunge most typically means the market will be bullish again.
A bull trap, on the other hand, is the topsy-turvy version of a bear trap. Instead of making you think a bear market is on the verge, bull traps are fake rallies that give you hope a long-term downtrend is transitioning into an uptrend. Also called a dead cat bounce, a bull trap often triggers fear of missing out (FOMO) buying and tricks you into entering long positions to get into a crypto position at the start of another bull market.
Just like bear traps, bull trap rallies don’t last long, and it’s usually only a matter of days before selling pressure erases the gains of a short-term rally and the cryptocurrency continues its downward movement.
What do Crypto Traders do During a Bear Trap?
Unless crypto traders know about risk management tools like stop-losses and take-profit orders, trading around sudden price dips is tricky. Long-term crypto traders often HODL their crypto portfolio during volatile price moves or buy more of their favorite cryptocurrencies during price declines to reduce their cost per coin. Contrarian traders, conversely, open long positions during sudden downturns to capitalize on a price recovery if they believe a cryptocurrency is in a short-lived bear trap. Alternatively, some traders use crypto derivative products like short perpetuals, futures, or put options to hedge their long-term crypto portfolio and profit from a digital asset’s short-term price decline.
High-risk strategies like shorting and selling call options are also popular ways to bet against a cryptocurrency’s price, but they expose traders to uncapped losses if they mistake a bear trap for a trend reversal.
If you want to trade cryptocurrencies during volatile moves, consider the risk of a bear trap and set your preferred price levels beforehand to cut losses if the market moves in the opposite direction.
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