The term "Falling knife" brings up an instinctive sense of danger, caution, and the instinct to withdraw one's hand. In trading, the idea of a falling knife is equally deemed dangerous. It refers to the act of buying an asset that is in steep decline—an approach viewed as risky, akin to catching a knife as it plummets to the ground. However, for some traders, a falling knife could also signify an opportunity. Keep reading to learn more.
What is a Falling knife and what does it tell you in trading?
The concept of a falling knife in trading is straightforward but comes with its risks. It refers to a situation where the price or value of a security, often a stock, is dropping rapidly. This phenomenon gets its name from the old saying, "don't try to catch a falling knife," which means you should not rush to buy a rapidly declining asset.
In trading terms, a falling knife signifies a bearish market condition where the price is expected to continue to go down for a while. The term is used to caution traders against buying into an asset too early before it has reached its bottom.
When traders see a falling knife, it tells them that the market sentiment for that particular asset is significantly negative, and it may continue to fall further. However, some traders might view it as a potential buying opportunity, hoping to catch the asset at its lowest point before it rebounds.
It's important to note that trying to "catch a falling knife" can be risky because if the price continues to fall, the trader could incur significant losses. Therefore, it's generally recommended to wait for confirmation that the price has indeed bottomed out and started to recover before stepping in to buy.
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How to use a Falling knife?
- Identify the cause: A falling knife could occur due to various reasons like earnings reports, economic reports, technical breakdown, or fundamental deterioration. It's crucial to identify the reason behind the sharp drop in price. This will help you understand whether the drop is temporary or indicative of a deeper issue.
- Research the fundamentals: If the cause of the price drop doesn't significantly affect the company's overall health or future prospects, it could present a buying opportunity. For instance, if a company's stock price drops due to a temporary issue that doesn't impact its long-term prospects, it might be an opportunity to buy the stock at a discount.
- Wait for confirmation: Catching a falling knife can be risky as the price may continue to fall. Therefore, it's generally safer to wait for confirmation that the price has bottomed out and started to recover. This could be in the form of a bullish reversal candlestick pattern or other technical indicators showing a change in trend.
- Set stop-loss orders: Given the risk associated with trying to catch a falling knife, it's crucial to use stop-loss orders to limit potential losses. A stop-loss order automatically sells the security when it reaches a certain price, preventing further losses.
- Monitor regularly: Keep a close eye on the stock and the market conditions. If the factors that caused the price drop worsen or if the stock's fundamentals deteriorate, it might be best to sell the stock.
Example of a Falling knife
A classic example of a falling knife situation occurred with the stock of NVIDIA Corporation (NVDA) in the fourth quarter of 2018. The stock, which had been on a steady uptrend for years, suddenly saw a sharp drop in price.
In October 2018, NVDA was trading at around $289.36. However, over the next two months, the stock price plummeted, reaching a low of $133.31 by December 2018. This represented more than a 50% drop in price, making it a clear example of a falling knife.
The main reasons behind this drop were disappointing earnings and a slowdown in demand for its products. Despite these negative factors, some traders might have seen this as a buying opportunity, hoping that the price would rebound.
Sure enough, those who "caught the falling knife" and bought the stock at its lowest point would have made significant gains. By February 2020, the stock had rebounded to trade at around $270, nearly doubling from its low point.
In this case, traders would have needed to assess NVIDIA's fundamentals and determine whether the price drop was temporary or indicative of deeper issues.
Limitations of a Falling knife
It's critical to recognize that not all falling knives can or should be caught. Many market downturns signify a meaningful shift in the asset's value proposition or the economy at large. Failing to differentiate between a temporary dip and a sustained decline could lead to significant losses.
Moreover, even in instances where a falling knife does signal an eventual rebound, the timing could be a formidable obstacle. Entering a position too early could mean enduring further losses before the anticipated recovery takes hold.
Traders, especially those new to the market, should proceed with utmost caution when considering a falling knife. It’s a strategy that requires not only a thorough understanding of market dynamics but also a disciplined approach to risk management.
Summary
As with any aspect of trading, the most reliable compass is knowledge. Delve into the specifics of the market conditions and the assets involved. Arm yourself with information, seek multiple sources of analysis, and most importantly, practise a cool-headed approach to risk. Before you try out this strategy, it's recommended you test it out with a demo trading account so as to familiarise yourself with the strategy first before depositing real funds. Download the Skilling demo account for free today.
