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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.
What a Falling Knife Tells You
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. In practice, however, there are many different profit points with a falling knife. If timed perfectly, a trader that buys at the bottom of a downtrend can realize a significant profit as the price recovers. Likewise, piling into a short position as the price falls and getting out before a rebound can be profitable. Moreover, even buy and hold investors can use a falling knife as a buy opportunity provided they have a fundamental case for owning the stock.
That said, there is a very real risk that the timing will be off and there could be significant losses before any gains. So many traders still pay lip service to the adage. 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 after the fall or looking at the relative strength index (RSI) for signs of a stronger uptrend before buying into the new trend.
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