What is a Bear Trap?
A “bear trap” happens when a short seller thinks a stock will keep going down but then it goes way up instead and they lose a lot of money. Short sellers bet against stocks. They borrow shares and sell them, planning to buy them back cheaper later and pocket the difference. But if the stock goes up a ton, the short seller has to buy back at a much higher price. This is called “covering their position.” If they can’t afford to do that because the stock is zooming up too fast, they are in a bear trap.
Why It’s Called a “Bear Trap”
The name comes from how a bear trap catches a bear. The bear steps in it thinking it’s safe but then SNAP! The trap springs shut and the bear is stuck. Same thing with a short seller. They step into a short position expecting the stock to drop. But then BAM! The stock surges and traps the short seller in a losing trade.
Short Sellers Bet Stocks Will Fall
Here’s how short selling works. Say a stock is at $100. A short seller borrows 100 shares and sells them for $10,000. The short seller hopes the stock tanks to $50. If it does, they can buy the 100 shares back for $5000, return the shares to the lender, and keep the $5000 profit. But if the stock soars to $200, the short seller has to buy back the shares for $20,000. Ouch! Now they have a $10,000 loss. The higher the stock goes, the bigger the loss. If they run out of money to buy back the shares, they’re trapped!
What Causes a Bear Trap?
A few things can spring a bear trap. Maybe the shorted company reports amazing earnings. Maybe they get bought out. Or maybe the whole market takes off in a huge rally. The short seller may have bet against one stock, but a rising tide lifts all boats. Even a crummy stock can get swept up in an overall market surge.
Short Squeezes Fuel Bear Traps
Sometimes it’s other traders gunning for the short sellers. They buy the stock on purpose to drive the price up and “squeeze” the shorts. As the stock rises, the short sellers buy back shares to cut their losses. But this buying just pushes the stock up more, forcing more short covering, causing the stock to spike. Before you know it, bam! Every short is scrambling to cover and get out, trampling each other and driving the stock to crazy heights.
Emotion and Herd Mentality
When a short squeeze takes hold, emotion and herd mentality kick in. Shorts panic and rush to cover at any price. Nobody wants to be the last one out. Fear and greed can make people irrational. Shorts may take huge losses just to end the pain. Longs smell blood in the water. They keep buying to stick it to the shorts.
Famous Bear Traps
Some epic bear traps have gone down in market history. Let’s look at a couple.
Volkswagen’s Infinity Squeeze
In 2008, billionaire Porsche CEO Wendelin Wiedeking secretly bought tons of Volkswagen options. At the same time, hedge funds had shorted 12% of VW’s shares, expecting them to fall. But Porsche’s buying forced the shorts to cover. In two days, VW stock surged 348%, briefly making it the world’s most valuable company! The short sellers got massacred, losing an estimated $30 billion. It was called the “infinity squeeze” because VW stock seemed to go almost to infinity.
Tesla’s Wild Ride
Tesla is a favorite target of short sellers. They think the stock is overvalued. But they’ve been burned again and again betting against Elon Musk. In 2020, Tesla soared over 700%, costing shorts around $40 billion! Whenever shorts piled in, thinking for sure THIS time it’ll crash, Musk would tweet something crazy, or report blowout numbers, or announce a stock split, and bam! The stock would take off like a rocket ship, obliterating anyone on the wrong side of the trade.
How to Avoid Bear Traps
Bear traps can blow up your account in a hurry! A few tips to dodge them:
Don’t Bet the Farm
Only risk what you can afford to lose. A short position is theoretically open to unlimited losses. You can lose way more than 100%. So don’t bet your whole wad on one trade.
Use Stop Losses
Place stop-loss orders the minute you enter a trade. Yeah, sometimes you’ll get stopped out right before the stock turns your way. That’s trading. A small loss beats getting trapped in a massive loser every time.
Keep an Eye on Short Interest
Check what percent of a stock’s float is short. You can find this on most financial websites. If short interest is really high, watch out! That’s just begging for a squeeze.
Stay Humble
Markets have a way of humbling cocky traders. Don’t assume a stock HAS to fall. There’s no law saying an overvalued stock can’t get even MORE overvalued before it crashes. Markets can stay irrational longer than you can stay solvent. Hubris has blown up many a short seller.
The Wrap on Bear Traps
Trading is risky. Short selling is extra risky. A bear trap can torch your capital fast if you get caught on the wrong side. Respect the power of a short squeeze. Use smart risk management. Stay humble. Or just be a long-only investor! Let the short sellers tangle with the bear traps while you enjoy the long-term rise of the market.
