Trading Bear Trap Explained

If you’re thinking about short-selling or have done any research, you might have heard the term “bear trap.” This is what happens when a stock or other security stops dropping and unexpectedly begins rising. When this happens, anyone who was betting on the stock to go down ends up losing money, even if the stock’s increase is only temporary.

Since people who expect the market to go down are called “bears,” this phenomenon is known as a “bear trap.” What does this mean for you? Let’s take a closer look, and find out! 

What Is a Bear Trap?

In some cases, there’s a consensus among investors that a particular stock is on a downward trend. Maybe the entire sector is declining. Maybe the company has management issues, or has just experienced a scandal. Investors will oftentimes bet against these stocks via short selling or other methods. When that stock reverses course – or never goes down in the first place – a bear trap has happened.

Bear traps pose a particular risk, because you could potentially lose more than 100% of your investment. That’s not possible with most kinds of investments. Even if you buy a stock and the value drops to a penny, you’ve only lost the money you invested.

But short selling normally requires a margin, which exceeds as the value of the stock goes up. Unlike a declining stock, which can only drop to zero, a rising stock has a theoretically unlimited ceiling. This means there’s no limit on the losses you could take. Here’s how that works:

Suppose you’ve borrowed 100 shares of ABC company at $50 a share. You short sold these shares, netting $5,000 in cash. You plan to close out your position when the stock drops to $45 a share. At a price difference of $5 per share, you’ll pocket a cool $500.

Unfortunately for you, ABC company has a surprisingly strong quarter, and the shares rise to $55 a share. If you’re lucky, you’ll be able to ride things out until the stock goes down again. But if you’re not, your broker may require you to deposit more cash to cover the difference. They might even force you to close the position, which means that instead of making $500, you’re taking a $500 haircut.

Short Selling and Bear Traps – What You Need to Know

The most common method of betting on a stock to go down is called “short selling.” When you short sell, you borrow a stock from your broker, then immediately sell that stock. In the future, you buy the stock back and return it to the broker.

This works because you aren’t borrowing a certain amount of money; you’re borrowing a certain number of shares. If those shares are worth more when you sell them than when you buy them back, you’ll be able to keep the difference. After all, you returned all the shares – it’s not your fault they’re worth less than when you borrowed them.

The problem here is obvious. When you short sell, you’re in debt to your broker. For this reason, it’s understandable that your broker will want some kind of collateral. This collateral is called “margin,” and the basic rules are set by FINRA. Under FINRA rules, you need to have the greater of 30% of the stocks’ value in margin, or $5 per share. Brokers may charge more, but not less, than these amounts.

So if you shorted a stock worth $10 per share, you’d need to deposit an additional $5 per share with your broker to cover the margin. If the stock is worth $100, you’d have to pay $30 per share.

The bear trap hits when your stock price rises so far that you no longer have enough margin to cover the current value. At that point, your broker will issue a margin call, and you’ll have one of two choices: either deposit more money, or close out your position and eat your losses.

What Does This Mean for Me?

The good news about bear traps is that not everybody has to worry about them. If you’re not short selling, you’re not exposed to the trap. On the other hand, if you’re using margin and trying to short stocks, bear traps are a very real threat. Then again, all investments come with inherent risks, so bear traps are really nothing special.

One way to mitigate the risk of a bear trap is to buy put options on a stock. This still allows you to make a profit if the stock goes down. But with a put option, your potential losses aren’t infinite. They’re limited to the premium you paid when you bought the option.