The Case of the Falling Knife

falling knifeFalling 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 be translated to mean, wait for the price to bottom out before buying it. A falling knife can quickly rebound – in what’s known as a whipsaw—or the security may lose all of its value, as in the case of a bankruptcy.

The term suggests that buying into a market with a lot of downward momentum can be extremely dangerous. In practice, however, there are many different profit points. If timed perfectly, a trader that buys at the bottom of a downtrend can realize a significant profit as the price recovers. Likewise, piling into a short position as the price falls and getting out before a rebound can be profitable. Moreover, even buy and hold investors can use a falling knife as a buy opportunity provided they have a fundamental case for owning the stock.

That said, there is a very real risk that the timing will be off and there could be significant losses before any gains. So many traders still pay lip service to the adage. Instead of trying to catch the falling knife, traders should look for confirmation of a trend reversal using other technical indicators and chart patterns. An example of a confirmation could be as simple as waiting for several days of upward momentum after the fall or looking at the relative strength index (RSI) for signs of a stronger uptrend before buying into the new trend.

How to Use a Falling Knife?

As mentioned, there are ways to profit from a falling knife. Many of the trading approaches are time sensitive and require more tools than simply identifying a stock seeing a sharp drop. However, for a fundamental case for catching a falling knife can be there depending on the reason for the drop.

Causes

~ Earnings Reports: Companies that report their earnings are often subject to volatile swings. If the financial results are lower than expected, the stock may become a falling knife until the market reaches an equilibrium.
~ Economic Reports: Major indexes are often influenced by economic reports, such as employment reports or FOMC meetings. If these reports are negative, stocks can move sharply lower in response.
~ Technical Breakdown: Some falling knives occur due to technical, rather than fundamental, factors. If a security breaks down from key support levels, the price can move sharply lower before finding support below.
~ Fundamental Deterioration: This occurs when the company underlying the stock either badly misses on a key performance indicator like sales, earnings or so on. It also happens when companies are found to be doing something fraudulent or suffering damage in the media.

If the circumstances that led to the falling knife are temporary or do not alter a buy and hold investor’s case for investing, then a falling knife could be a buying opportunity. For traders and those with a shorter timeframe, it is difficult to time bullish trades correctly.

Difference Between a Falling Knife and a Spike

A falling knife is specifically a sharp drop. A similar type of trading slang is a spike, which refers to a sharp movement in price action either up or down. In practice, however, a spike is most often associated with an upward movement.

Limitations

There are many cases where a sharp fall is an opportunity. From a trading perspective, many of these required some form of confirmation, such as a moving average convergence divergence (MACD) indicator showing positive divergence. So a falling knife – an ill-defined chart formation at best – is not really the most significant part of a trade playing off of a breach of support or a true reversal.

Summary

~ Falling knife refers to a sharp drop, but there is no specific magnitude or duration to the drop.
~ It is generally used as a caution not to jump into a stock or other asset during a drop.
~ Traders will trade on a sharp drop, but they generally want to be in a short position and will use technical indicators to time their trades.

 


 

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