What is a falling knife?
A falling knife is a colloquial term for a rapid drop in the price or value of a security. The term is commonly used in phrases like “don’t try to catch a falling knife”, which can mean “wait for the price to go down before you buy it”. A falling knife can quickly rebound – in what is called a scroll saw – or the title can lose its value, as in bankruptcy.
Key points to remember
- The falling knife refers to a brutal fall, but there is no specific amplitude or duration for the drop before it constitutes a falling knife.
- A falling knife is generally used as a precaution to not jump into a stock or other asset during a drop.
- Traders will trade on a sharp drop, but they usually want to be in a short position and will use technical indicators to time their trades.
What does a falling knife tell you
The term falling knife suggests that buying in a market with a lot of downward momentum can be extremely dangerous – just like trying to grab a falling knife. In practice, however, there are many different profit points with a falling knife. If properly timed, a trader who buys at the bottom of a downtrend can make a large profit as the price recovers. Likewise, stacking in a short position when the price drops and exiting before a rebound can be profitable. Additionally, even investors who buy and hold can use a falling knife as a buying opportunity provided they have a fundamental case for owning the stock.
That said, there is a very real risk that the timing will be delayed and there could be significant losses before any gain. So many traders continue to greet the adage. Instead of trying to “catch the falling knife”, traders should seek confirmation of a trend reversal using other technical indicators and chart models. An example of confirmation could be as simple as waiting several days for upward movement after the fall or looking at the Relative Strength Index (RSI) for signs of a stronger uptrend before joining the news. trend.
How to use a falling knife?
As mentioned, there are ways to take advantage of falling knives. Many trading approaches are time sensitive and require more tools than simply identifying a falling stock. However, for a basic case of catching a falling knife, there may be some reason for the fall.
There are many potential causes for a knife to fall, including:
- Results reporting: Companies that report their results are often subject to volatile fluctuations. If the financial results are lower than expected, the action can become a falling knife until the market reaches equilibrium.
- Economic reports: The main indices are often influenced by economic reports, such as employment reports or FOMC meetings. If these reports are negative, stocks may fall sharply in response.
- Technical Failure: Some knives that fall occur due to technical rather than fundamental factors. If a stock breaks down from key support levels, the price may drop significantly before finding support below.
- Fundamental deterioration: this occurs when the company underlying the security seriously lacks a key performance indicator such as sales, profits, etc. This also happens when companies are found to be committing fraudulent acts or suffering damage in the media.
If the circumstances that led to the fall of the knife are temporary or do not change the case of an investor who buys and holds to invest, then a falling knife could be a buying opportunity. For traders and those with a shorter time frame, it is difficult to properly synchronize bullish transactions.
Example of a falling knife
The following table shows an example of a falling knife and the danger of trying to predict a bottom.
The stock has become a falling knife after moving away from its 50-day moving average. Traders Trying to “Catch Up on the Falling Knife” May Have Purchased About $ 8.50 When There Was A Brief Reprieve From Sales Pressure, But They Would Have Lost Money As Stock Lived about $ 6.00 before hitting bottom. Traders waiting for confirmation could have benefited from going from $ 6.00 to $ 10.00 the following month.
Difference between a falling knife and a pick
A falling knife is specifically a brutal fall. A similar type of trading slang is a spike, which refers to an abrupt movement in price action up or down. In practice, however, a peak is most often associated with an upward movement.
Limits of a falling knife
As mentioned, there are many cases where a sudden fall is an opportunity. From a business perspective, many of these elements required some form of confirmation, such as a moving average convergence divergence indicator (MACD) showing positive divergence. So a falling knife – ill-defined graphics at best – is not really the most important part of a trade that is played on a break in support or a true rollover.