What is a Falling Knife?

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.

Falling knife refers to a sharp drop, but there is no specific magnitude or duration to the drop before it constitutes a falling knife.

A falling knife is generally used as a caution not to jump into a stock or other asset during a drop.

Causes Behind a Falling Knife

A falling knife may happen for various reasons. The causes may include but are not limited to:

1. Poor earnings

When companies report their earnings numbers, and they are below expectations, the stock may drop and result in volatile swings until supply and demand for the stock re-stabilizes.

2. Equity offering

If a company requires the need to raise capital, it may issue additional shares to the public. It would result in current shareholder dilution, which would become the impetus to a sell-off.

3. Economic reports

If the Federal Reserve or a bank releases underwhelming or negative news regarding the current economic landscape, investors would quickly sell stocks or move assets to different types of investments causing stock prices to drop.

4. Support levels

If a security breaks below its support line, technical traders believe the price will continue to dive before reaching the next level of support.

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How to Use a Falling Knife?

As mentioned, there are ways to profit from a falling knife. Many of the trading approaches are time sensitive and require more tools than simply identifying a stock seeing a sharp drop. However, for a fundamental case for catching a falling knife can be there depending on the reason for the drop.

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.
  • Fundamental Deterioration: This occurs when the company underlying the stock either badly misses on a key performance indicator like sales, earnings or so on. It also happens when companies are found to be doing something fraudulent or suffering damage in the media.

Strategies to Generate Profit During a Falling Knife

A falling knife can be profitable if timed appropriately, assuming traders buy the stock near or at the bottom of a downwards trend. When prices begin to correct and recover, the realized gains can be enormous.

Another strategy that can be used is to short or sell the investment. If investors are capable of shorting the stock during a falling knife, they will gain the spread between selling the stock at a higher price and repurchasing it at a lower value.

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For long-term investors, a falling knife can be economically beneficial if they purchase the stock at any period during the downwards trend and hold it for several years, hoping that the price will appreciate.

Limitations of a Falling Knife

As mentioned, there are many cases where a sharp fall is an opportunity. From a trading perspective, many of these required some form of confirmation, such as a moving average convergence divergence (MACD) indicator showing positive divergence.

So a falling knife—an ill-defined chart formation at best—is not really the most significant part of a trade playing off of a breach of support or a true reversal.

Risks and Mitigations of a Falling Knife

The largest risk behind profiting from a falling knife is the timing and events. There is no guarantee that the stock price will whipsaw nor gradually regain momentum – in fact, bankruptcy can ultimately be the outcome. Therefore, it is important to take precautions when deciding to enter a trade that involves a falling knife pattern.

Rather than focusing solely on the falling knife, traders should substantiate their belief that the stock will eventually recover by analyzing historical trend reversals through technical indicators and chart patterns. For example, investors can look at the RSI for signs of strong upwards before buying in.