What’s the falling knife?

A sharp decline in a security’s value or price is called “a falling knife.” The expression is frequently used in expressions such as “wait for the price to bottom out before buying it” or “don’t try to catch a falling knife.” In a situation similar to a whipsaw, a falling knife can immediately rebound, or the security can completely lose all of its value.

The Message of a Falling Knife

The phrase “falling knife” implies that investing in a market experiencing significant downward momentum can be pretty risky, much like attempting to catch a real falling knife. In actuality, though, there are several opportunities to benefit from a falling knife. A trader who purchases at the bottom of a downtrend and times it precisely might win handsomely when the price rises. Similarly, it might be advantageous to enter a short position when the price drops and exit before a comeback. Furthermore, if they have a strong argument for owning the company, even buy-and-hold investors can take advantage of a falling knife as a buying opportunity.

There is a genuine chance that the timing will be inaccurate, which might result in significant losses before any profits. The adage still receives lip service from a lot of dealers. Instead of attempting to “catch the falling knife,” traders should use chart patterns and other technical indicators to find proof of a trend reversal. A straightforward confirmation would be to hold off on purchasing into the new trend until many days following the decline or to monitor the relative strength index (RSI) for indications of a more robust upswing.

How Do I Use a Knife That Falls?

As previously said, there are methods to make money from a falling knife. Several trading strategies are time-sensitive and call for additional resources than just spotting a company that is experiencing a significant decline. Nonetheless, depending on the cause of the drop, there may be a primary argument for intercepting a falling knife.

There are several possible reasons why a knife could fall, such as:

• Reports on results: Businesses that release their results are frequently prone to sharp fluctuations. If the financial results fall short of expectations, the stock can plunge until the market finds balance.
• Economic data: Economic data, such as employment reports or FOMC meetings, frequently impact significant indices. Should these findings be unfavorable, stocks may react by plunging dramatically.
• Technical Breakdown: Technical issues, not fundamental ones, are sometimes the cause of falling blades. A security’s price may drop precipitously before finding support below it if it breaches crucial support levels.
• Fundamental Deterioration: When a firm that supports the stock either fails a critical performance metric, such as sales or earnings, or another one severely, this happens. It also occurs when businesses are discovered to be engaging in dishonest behavior or face negative publicity.

Falling knife situations may present a purchasing opportunity if they are transient or do not undermine the rationale for investment made by buy-and-hold investors. It is challenging for traders and individuals with a shorter duration to appropriately time bullish bets.

An Example

The following graphic shows the dangers of predicting a bottom using a falling knife scenario.
The stock fell after breaking above its 50-day moving average. Traders trying to “catch the falling knife” may have bought at $8.50 during a brief respite in selling pressure, but the stock dropped to $6.00 before bottoming out. The following month, prices rose from $6.00 to $10.00, benefiting traders who waited for confirmation.

What Separates a Spike from a Falling Knife

More precisely, it is a sharp descent. A spike, which denotes a sudden up or downshift in price activity, is a comparable term in trading jargon. In actuality, though, an upward movement is typically connected with a spike.

Constraints of a Falling Blade

As previously said, a steep decline can frequently present an opportunity. Many traders required proof, such as a positive MACD indicator. Thus, a falling knife, or imprecise chart formation, is not the most critical aspect of a trade that capitalizes on a break of support or reversal.

Conclusion

• Sharp drops define a falling knife, regardless of size or length.
• A dropping knife warns against buying a stock or other commodity as the price drops.
• Traders use technical indicators to short amid a steep fall.