A bear trap occurs when shorts take on a position when a stock is breaking down, only to have the stock reverse and shoot higher. This counter move produces a trap and often leads to sharp rallies.
Setup for Bear Traps
Bear traps have a very basic setup. You will want a recent range to be broken to the downside with preferably high volume. The stock will need to get back above support within 5 candlestick bars, then explode out of the top of the range. The last component of the setup is that the stock should have a decent price range. A wide price range is critical, as it increases the odds that the stock will have room to trend in order to book quick profits.
Why do Bear Traps produce sharp rallies?
The first wave of buying will occur when the most recent swing high is exceeded, due to the number of shorter term traders who have their stops slightly above the most recent swing high. The second wave of buying comes into play once the strong shorts realize that this is not just a dead cat bounce, but that the move has legs. This will produce the second bounce, which will often precede the short-term top in the counter move.
Example of a Bear Trap
If you have access to a charting service, take a look at the bear trap on 7/6 for the stock Agrium, Inc. (AGU). You will notice that the stock broke to fresh two-day lows, before having a sharp counter move higher.