The term “falling knife” is used as a common phrase that describes a rapid decline in value or price of an investment. It is employed in terms such as “don’t try to take a falling knife in your hand,” which could be translated to mean “wait till the prices drop before purchasing it.” A knife that falls can swiftly rebound – – referred to as the whipsaw–or the security could end up losing all its value when it comes to the instance of bankruptcy. default.
What a falling Knife Will Tell You
The phrase “falling knife” suggests that investing in markets that have an abundance in downward momentum could be very risky, just as trying to catch a falling knife. However, in practice there are a variety of potential profit opportunities with falling knives. If it is timed correctly it is possible for a trader who buys at the end of an downtrend will earn a substantial gain as the price rises. In the same way, adding to short positions as prices fall and exiting prior to a rebound is profitable. In addition, Buy and Hold investors are able to utilize a knife falling as an opportunity to buy if they have a solid argument for holding the shares.
However, there is a high chance that the timing may be incorrect and there could be substantial losses before gains. Many traders continue to adhere to the old adage. In lieu of trying “catch the knife falling away,” traders should look for evidence of a trend reversal by using other indicators in the chart and patterns. A possible confirmation can be as easy as waiting for a few days of positive momentum following the decline or examining an indicator like the the relative strength indicator (RSI) for signs of a greater uptrend before making a purchase on the new trend.
How do I Use the Falling Knife?
As previously mentioned, there are many ways to profit from a knife that is falling. Some of the strategies for trading need more equipment than just being able to identify a stock that is experiencing sharp decline. But, for a basic situation to stop the knife that is falling, it could be found based on the reason behind the fall.
There are a myriad of possible reasons for a knife to fall to occur, such as:
- Earnings Reports companies that release their earnings are usually affected by fluctuating fluctuations. If financial results are less than what was expected and the stock is deemed to be at risk, it could become an ebb and flow until the market has reached an equilibrium.
- Economic Reports: The most important indexes are usually affected by economic reports, like the employment report or the FOMC meetings. If the reports are negative, the stock market may be in sharp decline as a result.
- Technical Breakdown: Many falling knives are caused by more fundamental, not technical aspects. When a security fails to recover from key levels of support the price could plunge sharply before finding support at a lower level.
- Fundamental Deterioration occurs when the company that is the source of the stock fails to meet expectations on an key performance indicator such as earnings, sales or and so on. It can also happen when companies are discovered to be committing fraud or have suffered damage in the media.
If the events that caused the fall of the knife are not permanent or are not affecting an investor who buys and holds their reason to investing in the future, then the knife’s fall could be an opportunity for buying. For traders and investors with smaller timeframes it can be difficult to predict the right bullish trades.
An example of a falling Knife
The following chart illustrates an example of a knife falling and highlights the risk in trying to anticipate the bottom.
The stock was an eagle after it moved away from it’s 50-day moving average. The traders trying to “catch the knife that was falling” might have invested approximately $8.50 during an opportunity to escape the selling pressure. However, they’d be losing funds as the stock fell towards a low of $6.00 before it finally topped out. The traders who were waiting for confirmation may benefit from the rise of $6.00 to $10.00 over the course of the month.
The Difference Between a Falling Knife and Spike
A knife falling is sharp drops. Another type of trading slang term is spike, which is the sharpness of price action, either up or down. However, in reality it is typically connected with an upward trend.
The Limits of a Knife that is falling Knife
As we’ve mentioned in the previous paragraph, there are numerous instances in which a sharp drop can be an opportunity. From a trader’s perspective the majority of these require the use of some type of confirmation for example, the Moving average Convergence Divergence (MACD) indicator showing positive divergence. A falling knife, which is a poorly defined chart pattern at best–isn’t necessarily the most important element of a trade based off a breach of support, or even a real reverse.