What Is a Falling Knife and How Do Investors and Traders Use It?

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.

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.

There are many potential causes for a falling knife to occur, including:

• Earnings reports: Companies that report their earnings are often subject to volatile swings. The stock may become a falling knife until the market reaches an equilibrium if the financial results are lower than expected.
• Economic reports: Major indexes are often influenced by economic reports such as employment reports or FOMC meetings. Stocks can move sharply lower in response if these reports are negative.
• Technical breakdown: Some falling knives occur due to technical rather than fundamental factors. The price can move sharply lower before finding support if a security breaks down from key support levels.
• Fundamental deterioration: This occurs when the company underlying the stock badly misses on a key performance indicator like sales or earnings. It can also happen when companies are found to be doing something fraudulent or suffering damage in the media.

A falling knife could be a buying opportunity if the circumstances that led to it are temporary or if they don't alter a buy-and-hold investor's case for investing. It's difficult for traders and those with a shorter timeframe to time bullish trades correctly.

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 at 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.

Falling Knife vs. a Spike

A falling knife is a sharp drop. A similar type of trading slang is a spike, which refers to a sharp movement in price action either up or down. But a spike is most often associated with an upward movement in practice.

Limitations of a Falling Knife

There are many cases in which a sharp fall can provide an opportunity. Many of these require some form of confirmation, such as a moving average convergence divergence (MACD) indicator showing positive divergence. A falling knife is an ill-defined chart formation at best. It's not the most significant part of a trade playing off a breach of support or a true reversal.

The Bottom Line

A falling knife describes the process of a security rapidly and significantly plunging in price or value. It’s not defined by exact measurements or spreads but is rather a warning to pause and take a deep breath before jumping into a stock. It’s possible to make money with a falling knife but buying into a market that’s plunging can be dangerous and result in wounds so proceed with care.

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