A bear trap is an investing pattern that happens when a falling security reverses course and begins rising again, temporarily or permanently. Investors who have bet against the market or individual security are called bears. They may lose money when prices begin to rise as they are forced to sell by margin calls or otherwise cover their short positions.
Bear traps can force investors who are shorting a security to lock in losses, even if the long-term trend of a stock is downward. Learn how bear traps work and what they mean for investors.
Definition and Examples of a Bear Trap
A bear trap occurs when a stock or another security that is losing value suddenly reverses course and begins to gain value instead. It can also occur when a stock that looks poised to begin falling unexpectedly maintains an upward trend. Bearish investors who have shorted or bet against that stock may experience losses.
Note
Betting against a stock usually involves margin or derivatives, which increases the risk of investing. Theoretically, since the price of the security can keep rising, there is potential for unlimited loss.
The increase in the security’s value and its corresponding loss could cause a broker to initiate a margin call against the investor with a short position, forcing them to deposit more funds or sell securities for a loss.
For example, imagine that an investor has short-sold shares of XYZ for $40, but those shares are on a downward trend.
XYZ falls to $35, which means you should be able to turn a profit if you close the position. However, before you purchase the shares to do so, XYZ starts to rise and reaches $45. If you close the position now, you’ll lock in a loss of $5 per share. Depending on the number of shares you short sold and the equity in your account, your broker may force you to deposit more cash or close the position, locking in the loss.
Even if the rise in value is a short-term spike and XYZ later continues its downward trend, the bear trap has forced you to close the position or deposit extra cash to avoid a margin call. If the stock continues to trend upward, your losses will increase until you close the position.
How Does a Bear Trap Work?
A bear trap works because brokers require investors who bet against a security (bearish investors) to cover their liabilities when a stock gains value instead of losing value. This typically means maintaining a set level of equity in your account compared to your debt.
One way that bearish investors can bet against a stock is by short-selling it, which involves borrowing shares to sell and hoping to buy them back at a lower price later. Generally, short-selling means borrowing shares from your broker, indebting you to them.
The amount you owe your broker is equal to the number of shares borrowed multiplied by the current market price of those shares. If the price of the shares falls, your debt will fall. If the shares gain value, your debt will increase.
For example, if you short sold 50 shares of XYZ and it currently trades at $40, you'd owe $2,000 to your broker (50 x $40). If XYZ increased in value to $50, you'd owe your broker $2,500 (50 x $50).
Note
There are FINRA rules regarding how much you’re allowed to borrow from your broker, though your broker may set different limits. According to the rule, margin maintenance for short-selling a stock trading at a price more than $5 is 30% of the stock’s current price per share you’ve shorted or $5 per share, whichever is greater.
In the example above, if you shorted XYZ and the stock is currently worth $50, you’d need at least $15 in your account for each share you shorted. If XYZ rises to $100, you would need $30 in your account for each share you shorted.
The bear trap will spring when the price of the stock you shorted rises to the point that you no longer meet your broker’s equity requirements in comparison to the number of shares you’ve shorted. When that happens, you’ll get hit by a margin call.
You’ll either have to immediately close the short position (locking in losses) or deposit additional cash. If prices continue to rise, you’ll have to continue depositing cash or accept even greater losses.
What It Means for Individual Investors
Individual investors don’t need to worry about bear traps unless they’re investing using margin and betting against the market or individual stocks. If you are betting against a stock, you should keep an eye out for bear traps.
One way to stop bear traps is to avoid short positions with large or infinite-potential liability. For example, instead of short selling a stock, you can buy put options. With a put, you’ll profit if the price of a stock falls, but your maximum loss is equal to the premium you paid for the option.
Key Takeaways
- Investors who bet on a stock’s price to fall are called bearish investors.
- Bear traps occur when investors bet on a stock’s price to fall but it rises instead. Rising stock prices cause losses for bearish investors who are now “trapped.”
- Typically, betting against a stock requires short-selling, margin trading, or derivatives.
- Bear traps “spring” as brokers initiate margin calls against investors.
- You can prevent bear traps by avoiding short positions or using short strategies with limited losses, like buying puts.
