What is a falling knife, and how do investors and traders use it?

What is a falling knife?

A falling knife is a general term for a rapid drop in the price or value of a security. The term is commonly used in phrases such as, “don’t try to catch a falling knife,” which can be translated to mean, “wait for the price to bottom before buying.” A falling knife can quickly bounce back – in what is known as a whipsaw – or the security can lose all its value, as in the case of a bankruptcy.

What a falling knife tells you

The term falling knife suggests that buying into a market with a lot of downward momentum can be extremely dangerous – just like trying to catch an actual falling knife. In practice, however, there are many different profit points with a falling knife. If the timing is perfect, a trader who buys at the bottom of a downtrend can realize a significant profit as the price recovers. Likewise, it can be profitable to pile into a short position as the price falls and get out before a pullback. Moreover, even buy-and-hold investors 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 off and that 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 a few days of upward momentum after the drop or watching the relative strength index (RSI) for signs of a stronger uptrend before entering the new trend shopping.

How to use a falling knife?

As mentioned, there are ways to take advantage of a falling knife. Many of the trading approaches are time sensitive and require more tools than simply identifying a stock that is seeing a sharp decline. But for a fundamental case for catching a falling knife there may be, depending on the reason for the fall.

There are many different possible causes for a falling knife, including:

Earnings Reports: Companies that report their earnings are often subject to volatile swings. If the financial results are lower than expected, the stock can 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 may move sharply lower in response.

Technical collapse: Some falling knives occur due to technical, rather than fundamental, factors. If a security breaks down from key support levels, the price may move sharply lower before finding support below. Fundamental decline: This occurs when the company underlying the stock misses either a key performance indicator such as sales, earnings, and so on. This also happens when companies are found to be doing something fraudulent or suffer damage in the media.

If the circumstances that led to the falling knife are temporary or do not change a buy-and-hold investor’s case for investment, a falling knife can be a buying opportunity. For traders and those with a shorter time frame, timing bullish trades correctly is difficult.

Example of a falling knife

The following chart shows an example of a falling knife and demonstrates the danger of trying to predict a bottom.

The stock became a bearish knife after moving off its 50-day moving average. Traders trying to “catch the falling knife” might have bought in around $8.50 when there was a brief period of selling pressure, but they would have lost money when the stock moved to a low of around $6.00 before they finally hit rock bottom. Traders waiting for confirmation could have benefited from the move from $6.00 to $10.00 in the following month.

Difference between a falling knife and a vein

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

Limitations of a falling knife

As mentioned, there are many cases where a sharp drop 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. Such a falling knife—an ill-defined chart formation at best—isn’t really the most important part of a trade that plays off of a breach of support or a true reversal.