What Is a Falling Knife?
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." It 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 its value as in the case of bankruptcy.
Key Takeaways
The term falling knife refers to a sharp drop.
• There's no specific magnitude or duration to the drop before it's considered to be a falling knife.
• A falling knife is generally used as a caution not to jump into a stock or other asset during a drop.
• Traders will trade on a sharp drop but they generally want to be in a short position and will use technical indicators to time their trades.
What a Falling Knife Tells You
The term falling knife suggests that buying into a market with a lot of downward momentum can be dangerous, just like trying to catch an actual falling knife. In practice, however, there are many profit points with a falling knife.
A trader who buys at the bottom of a downtrend can realize a significant profit as the price recovers if it's timed perfectly. Likewise, it can be profitable to pile into a short position as the price falls and get out before a rebound. Even buy-and-hold investors can use a falling knife as a buying opportunity if they have a fundamental case for owning the stock.
What Is a Falling Knife?
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." It 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 its value as in the case of bankruptcy.
Key Takeaways
The term falling knife refers to a sharp drop.
There's no specific magnitude or duration to the drop before it's considered to be a falling knife.
A falling knife is generally used as a caution not to jump into a stock or other asset during a drop.
Traders will trade on a sharp drop but they generally want to be in a short position and will use technical indicators to time their trades.
What a Falling Knife Tells You
The term falling knife suggests that buying into a market with a lot of downward momentum can be dangerous, just like trying to catch an actual falling knife. In practice, however, there are many profit points with a falling knife.
A trader who buys at the bottom of a downtrend can realize a significant profit as the price recovers if it's timed perfectly. Likewise, it can be profitable to pile into a short position as the price falls and get out before a rebound. Even buy-and-hold investors can use a falling knife as a buying opportunity if they have a fundamental case for owning the stock.
But many traders still pay lip service to the falling knife adage because there's a very real risk that the timing will be off and there could be significant losses before any gains are realized. Traders should look for confirmation of a trend reversal using other technical indicators and chart patterns instead of trying to "catch the falling knife."
An example of confirmation could be as simple as waiting for several days of upward momentum after the fall or looking at the relative strength index (RSI) for signs of a stronger uptrend before buying into the new trend.
How to Use a Falling Knife
There are several ways to profit from a falling knife. Many of the trading approaches are time-sensitive and require more tools than simply identifying a stock that's seeing a sharp drop. A fundamental case for catching a falling knife can be made depending on the reason for the drop.
But many traders still pay lip service to the falling knife adage because there's a very real risk that the timing will be off and there could be significant losses before any gains are realized. Traders should look for confirmation of a trend reversal using other technical indicators and chart patterns instead of trying to "catch the falling knife."
An example of confirmation could be as simple as waiting for several days of upward momentum after the fall or looking at the relative strength index (RSI) for signs of a stronger uptrend before buying into the new trend.
How to Use a Falling Knife
There are several ways to profit from a falling knife. Many of the trading approaches are time-sensitive and require more tools than simply identifying a stock that's seeing a sharp drop. A fundamental case for catching a falling knife can be made depending on the reason for the drop.