Should you try Catching a Falling Knife? Definition & Explanation

What is a Falling Knife?

A falling knife is used to refer to a rapid drop in the price of security such as a stock. In such cases, it is advisable for traders to patiently wait for the price to attain the lowest point before buying it again. Is catching a falling knife worth it?

A falling knife can instantaneously rebound even after the event and this is referred to as whipsaw. The security could equally lose all the values it possesses and lead to bankruptcy.

There is no precise duration or quantification for the drop that determines or defines a falling knife. A falling knife serves as a guard against hopping onto an asset such as stock during a fall.

Traders would want to be in a short position and adopt a technical trading indicator for them to trade on a sharp fall.

What a Falling Knife Tells You

A falling knife insinuates that jumping onto a market with huge downward momentum is overly risky. Just like you try catching a falling knife.

A trader can make a massive profit as soon as the price recovers after it has experienced a downtrend if accurately timed.

Similarly, getting into a short position as the price drops and moving out right before a rebound can as well be significantly profiting.

Trying to leverage on a falling knife can be very dangerous. And if you get the timing wrong, you are bound to experience a huge loss before any profit whatsoever.

Rather than you try catching a falling knife; be on the lookout for an affirmation of trend reversal by applying other technical trading indicators.

An instance of affirmation could be as basic as waiting it out for some days or better still observing the relative strength index (RSI) for strong uptrend indications before jumping onto a new trend.

There are two means for profiting out of a falling knife. Most trading techniques require time and more tools than mere figuring out a stock experiencing a rapid fall.

Causes of a Falling Knife

Knife fall occurs as a result of diverse and multiple factors. They include:

1. Insufficient earnings: when organizations give a report of their earnings and it lies below the expected value, the security may drop and lead to a volatile swing; until there is a balance in the demand and supply of security.
2. Balance offering: if an organization require the need to garner up capital, it might supply surplus shares to the public. This would lead to dilution of current shareholder, and this would turn to impulse to a selloff.
3. Resistance level: If stock breaks beneath the resistant level; traders are of the opinion that there will be a continual deep before attaining the next line of resistance.
4. Economic Reports: when the Federal bank announces disappointing reports pertaining to the current economic landscape; traders would rapidly sell off securities or transfer assets to a different type of investment leading to a drop in stock price.

Techniques for Raking in Profit During a Falling Knife

A falling knife can be significantly profitable if well-timed, should the investor purchase the stock close to or at the base of a downtrend. As soon as the price begins to recover and balance, the attained profit, in this case, would be huge.

In the case of a long-term trader, a falling knife can be economically profitable if they buy the security at any time during a downtrend and hold onto it for some years, envisaging it to appreciate with time.

Another technique that can be adopted is to sell off the asset or go short. If a trader manages to short a stock when a knife is falling. Such traders will benefit from the spread between disposing of the stock at a higher price and rebuying it at a lesser figure.

What does Catching a Falling Knife Mean?

This phrase is very common among investors. It denotes the trial of a trader to make up for the previous loss by of on the holding of an asset. The investor attempts to catch the knife by trying to make a purchase near or at the lowest point. After which the investor holds onto it for a while with the hope that it will rise to recover the previous loss.

Attempting to catch a falling knife doesn’t always translate to an error. Good securities are capable of suffering huge and unpredicted deeps. The issue lies with the time factor. Investors are too quick to jump into scenarios of this nature. And when price fails to bounce back as they have predicted, they end up panicking and selling untimely.

The error is here the investor allowing sentiments to take the better part of them and hence, making becoming very susceptible to mistake. It is vital to make up your mind to be wrong when attempting to catch a falling knife.

Also, try to limit your buy as much as possible, that way, you’ll keep emotion in check. Again, the larger the buy, the more likely you’ll make mistakes.

To begin with, you would have to have full confidence in your approach to buying. Because if you are wrong, it wouldn’t be of any significance whether your timing is right.

And on the other hand, if you are right and have a high confidence level, with poor timing, then you are in trouble. This methodology is not risk-free but it can be significantly profitable provided the market overreacts.