Do you know what it means to catch a falling knife in trading? When the price drops, 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. Are there things you can look at to keep you from catching a falling knife? Thankfully, yes!
We know there will inevitably be those who think they can still catch a falling knife. And they’ll likely have the same success as those who attempt to catch bullets in their teeth.
A few methods can be employed to lower your risk, which can be used in nearly all trading—the most important rule is to adhere to your plan. If your gut instinct says to change from that plan, you are not following this rule, and in the long run, you will suffer some bad losses.
What Does Catch a Falling Knife Mean?
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 buying a stock that has fallen sharply, catching it at its bottom. Then, gain on the rebound of the price. For example, look at the recent Ethereum price to catch a falling knife.
This Ethereum chart shows the price at $2332. So, it’s 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 by J.P. Morgan, 40% of all stocks experience a “catastrophic loss” (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 return? Or is this the beginning of extended bad news?
Dollar Cost Averaging
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 continue every two weeks.
This is classic DCA (dollar cost averaging); you won’t time the bottom, but the price will be the average throughout buying. As a modification, you can purchase the first $250 at $50 and 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 will need to commit to it. Remember, if a stock goes down 50%, it must go up 100% to return to the same level. Knives usually move quickly; your plan should be in place, not making decisions while watching the open market.
This is an example of trying to catch a falling knife on a daily chart $GLD. Notice the large green hammer candlestick after the sharp price decline. Most traders would have entered the trade when the price broke above the hammer and gone long. It was a good short-term trade but became a head and shoulders pattern.
MACD Indicator
We won’t delve into the math behind it, but the MACD can help reveal where an asset will go. 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 also end, and the falling knife risk is reduced.
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 the game is 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.
Final Thoughts on Catch a Falling Knife
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 a risk as you’ll find. But remember, those trying to catch a falling knife inevitably get cut. We know of no one that can 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.
Frequently Asked Questions
Catching a falling knife in investing is when a trader buys a security after a large drop in stock price. They are trying to buy the dip in hopes that the security will continue to rise, but it doesn't.
The best way to catch a falling knife is to look for a reversal pattern, such as a hammer or doji at the base of the drop. Watch to see if a bullish harami or engulfing pattern will confirm the reversal to the bullish side.
Never catching a falling knife means waiting for price action to give you the buy signal before unthinkingly purchasing the stock. Make sure to let the technicals confirm your buying decisions.
