Do you know what it means to catch a falling knife in trading? It’s when the price is dropping, you buy and it continues to drop. It’s like buying the dip but the stock keeps dipping. That’s a terrible feeling as you watch your trade go against you. Is there things you can look at to keep you from catching a falling knife? Thankfully, yes!
Do You Catch a Falling Knife?
Buy low and sell high; it just seems so easy. Just look for stocks, cryptos, or anything that’s price has gone down. You buy it and then wait for riches to come. This method is the idea behind catching a falling knife. Knife catching means to buy a stock that has fallen sharply, catching it at its bottom. Then gain on the rebound of the price. For example, let’s look at the recent Ethereum price to catch a falling knife.
Ethereum currently stands at $2332. So slightly down from our original purchase. This example is intended to show that knife catching is nearly impossible. Even seasoned traders can’t do it reliably.
According to an excellent study conducted by J.P. Morgan, 40% of all stocks experience a “catastrophic loss” (defined as 70% decline from peak value) from which they never recover. Even 13% of utilities are not immune to these fatal crashes. Make sure you know the reason for the knife drop. Is there any fundamental hope for the asset’s price to go back up? Or is this the beginning of extended bad news?
So Is There Any Hope for Knife Catching?
We know that that there will inevitably be those that think they can still catch a falling knife. And they’ll likely have the same success as those that attempt to catch bullets in their teeth.
A few methods can be employed to lower your risk, and these methods can be used in nearly all trading. The most important rule to adhere to stick to your plan. If your gut instinct says to change from that plan, then you are not following this rule, and in the long run, you are going to suffer some bad losses.
Dollar Cost Averaging (and Slightly Modified DCA)
If you wish to build a position, thinking an asset will rise over a few years, there’s plenty of time to accumulate the asset. For example, if you’re willing to risk $1,000 in a falling knife stock (currently at $50/share down from $100), you don’t need to buy all $1000 at once. Or you can buy $100 today, another $100 two weeks from now, and continuing every two weeks.
This is classic DCA (dollar cost averaging), you won’t time the bottom, but the price will be the average over the period of buying. As a modification, you can purchase the first $250 at the cost of $50, another $250 if/when it hits $45, 40, or 35 (the difference can be a dollar value that widens or shrinks or a percentage).
Whatever plan you decide, you must commit to it. Remember, if a stock goes down 50%, it must go up 100% to get back to the same level. Knives usually move very quickly; your plan should be in place, not making decisions while watching the open market.
What Should You Do If a Knife Is Falling?
Make sure you have an exit strategy if you catch a falling knife. This is especially important when trying to game a quick bounce from a whipsaw. Having a stop order in place could save you from getting killed; most knife catchers will buy low and sell lower.
Don’t Buy On the First Drop
When the bad news comes, two things will often follow. First, it is more likely that additional lousy information will follow, causing a second drop, and even if there is some good news shortly, there is likely more bad news to come in most cases.
Bad earnings are causing liquidity issues, but new funding has been found, but the board has chosen to fire the CEO; the current CFO will act as CEO till a new one is found.
Second, monkey see, monkey do, will often have other traders sell after the first big selloff, either from panic or stop orders.
So, wait for the second fall, and then you may begin buying, assuming that technical requirements (MACD below) support this bottom.
Moving Average Convergence Divergence Momentum Indicator (MACD)
We won’t delve into the math behind it, but the MACD can help reveal where an asset will go next. It’s a trend-following momentum indicator showing the relationship between two moving averages of an asset’s price. If an asset hits a new low, and so does the MACD, the downtrend is likely to continue. But with a rising MACD, the decline may be ending as well, and the falling knife risk is reduced.
Catch a Falling Knife Summary
If you find an asset that has dropped two or more times and the MACD indicates a reversing trend follow your plan and purchase with DCA or a modified DCA. This is about as low of risk as you’ll find. But remember, those trying to catch a falling knife inevitably get cut. We know of no one that can successfully do it on a reliable basis. If they can, they’re not sharing their secrets; so buyer beware. As with all investments, never put at risk more than you’re willing to lose, and good luck with your trades.