What is a Falling Knife
A falling knife is a colloquial term for a rapid drop in the price or value of a security. The term is commonly used in phrases like, "don't try to catch a falling knife," which can be translated to mean, "wait for the price to bottom out before buying it." A falling knife can quickly rebound - in what's known as a whipsaw - or the security may lose all of its value, as in the case of a bankruptcy.
BREAKING DOWN Falling Knife
The term falling knife suggests that buying into a market with a lot of downward momentum can be extremely dangerous - just like trying to catch an actual falling knife. If timed perfectly, a trader that buys at the bottom of a downtrend can realize a significant profit, but the odds are that the timing will be off and there could be significant losses before any gains. As a result, the general consensus among traders is: Don't try to catch a falling knife.
Instead of trying to "catch the falling knife," traders should look for confirmation of a trend reversal using other technical indicators and chart patterns. An example of a confirmation could be as simple as waiting for several days of upward momentum or as complex as looking at the relative strength index (RSI) for signs of a stronger uptrend before buying into the new trend.
What Causes a Falling Knife?
There are many different potential causes for a falling knife to occur, including:
- Earnings Reports - Companies that report their earnings are often subject to volatile swings. If the financial results are lower than expected, the stock may become a falling knife until the market reaches an equilibrium.
- Economic Reports - Major indexes are often influenced by economic reports, such as employment reports or FOMC meetings. If these reports are negative, stocks can move sharply lower in response.
- Technical Breakdown - Some falling knives occur due to technical, rather than fundamental, factors. If a security breaks down from key support levels, the price can move sharply lower before finding support below.
Example of a Falling Knife
The following chart shows an example of a falling knife and demonstrates the danger of trying to predict a bottom.
The stock became a falling knife after moving off of its 50-day moving average. Traders trying to "catch the falling knife" may have bought in around $8.50 when there was a brief reprieve from the selling pressure, but they would have lost money as the stock moved to a low of around $6.00 before finally bottoming out. Traders that waited for confirmation could have benefited from the move from $6.00 to $10.00 in the ensuing month.