Friday's Bear Trap

by Jay Pestrichelli on April 10th, 2013

Investopedia defines a Bear Trap as follows:
 
A false signal that the rising trend of a stock or index has reversed when it has not. A bear trap prompts traders to place shorts on the stock or index, since they expect the underlying to decline in value. Instead of declining further, the investment stays flat, or slightly recovers.

Here’s a good chart I found to give you an idea of what it looks like:
 
3 days after the worst jobs report of this bull market recovery, I’m prompted to pose the question if Friday’s report was a Bear Trap.  The fundamental-type data that disappointed so many and painted a poor picture for the jobs market AND potentially brought the Fed one step closer to ending QE had many investors spooked. Was this the catalyst needed for the long awaited pull-back of 2013? Well 3 days later the S&P 500 and the Dow are hitting new intra-day highs. So what is causing this?
 
As we said on Thursday  and Friday’s posts, it’s all about earnings and not to be too influenced by the jobs data. However we are now seeing an unforeseen consequence of the Friday morning sell off… it’s this Bear Trap situation. As the definition above explains, a sell signal prompts the bears to pile in and take short position on their much anticipated sell off. As the bears piled in with speculative puts and short positions in equities,  they were unfortunately caught on the wrong side over the next 3 days. We may not hear about it for a while, but those that went short were squeezed out with today’s gains being the final straw.
 
I suspect the bears that were waiting for the sell off ahead of Friday, levered up hoping to finally capitalize on their bias and hoped to be rewarded for their patience. With the S&P up over 3% from Friday’s bottom and the NASDAQ up over 4%, those using leverage found themselves in a sticky situation this morning as the market gapped up and realized they needed to cover buy to fight another day.
 
One other factor to consider is a bit of experience we have from our brokerage operation days. We know that 3 days tends to be the limit for most quick movements because by day 3 margin calls are due. This works for up and down movements, but brokers tend to cover the short positions faster because of the unlimited loss potential when short to the upside. Brokers don’t like selling out clients, of course, but they dislike losing their own money even more.  Hopefully the bears took our ongoing advice and hedged those as well.


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