Falling Knife: How to Invest cautiously!

The term Falling Knife in the stock market is an indication of danger, caution and the instinct to withdraw one’s hand. On the other side, investors also look for the buying opportunity in a falling knife as they seek to buy the stock that is in steep decline. Explore this blog to ascertain if falling knife is a buying opportunity or not!

What is a Falling Knife in Trading?

Falling Knife in trading is a straightforward concept that represents a significant drop in the prices of the assets due to some internal or external circumstances. The term signifies a sudden drop in the value of a security where it is also used in a phrase “don’t try to catch a falling knife” that clearly means not purchase the falling move instead wait for the prices to reach the bottom. An asset price can experience a significant drop due to reasons like negative news, poor earnings reports, or some other external factor.

In technical analysis, you can determine a falling knife when the share prices experience a sudden drop of 20% or 30% within a few weeks. In trading terms, the falling knife represents a bearish market condition that triggers a cautious behavior of investors as the prices are expected to go down for a while. And, when the security continuously breach the demand zones of weekly or monthly time frames.

Causes of Falling Knife

Identifying future price movements of any stock is not possible for any investor; the investments are based on presumptions and analysis. However, investors can relate some factors to identify if the prices are heading towards making a low or the prices can reverse in upwards direction. Investors might look for these signs:

Economic Cause

The primary cause of falling knife is economic uncertainties such as changes in interest rates, unemployment rates, inflation, GDP growth, etc. These causes can trigger sharp decline in an asset’s prices and hence leads to panic selling and steep price drops.

Business Model

Earning reports and company specific issues can lose investors confidence towards the asset hence resulting in rapid fall of stock prices. If the fundamentals of business are quite weak or it seems to be broken or unsustainable, in case of a falling knife, there are high possibilities of the prices to drop if the company doesn’t fulfill investor’s expectations. Therefore, investors must wait before buying a falling knife.

Signs of Fraud Activities

If the share prices are experiencing a falling knife, there are increased chances of malfeasance by the company like an accounting scandal or some other inappropriate/illegal activities.

Market Sentiments

During market volatility, negative sentiments spread quickly leading investors to sell their securities. It plays a huge role in causing a falling knife in stocks as well as other assets as the prices fall continuously. As we have seen during the crisis of 2008 and 2020 that widespread fear and uncertainty led to massive sell offs across various sectors.

Geopolitical Events

Geopolitical events such as wars, political instability or trade tensions lead to abrupt market reactions leading to uncertainty and fear among investors due to which they exit their positions rapidly.

How to use a Falling Knife?

Coming this far, we know how falling knife behaves as there is no surety about the next move of a share price. Let us know the steps that help an investor actually to make the use of falling knife:

Determine the Reason

A falling knife can occur due to weak earnings reports of the company, economic reports, technical breakdown or fundamental deterioration. It is crucial for an investor to analyze the actual reason for the sharp decline in prices. It can give insights whether the drop is temporary or can last for a longer period.

Analyze the Fundamentals

Deeply recognize the reason for a price drop that can significantly affect a company’s overall health or future prospects. If the prices are falling due to temporary issues or as an effect of market condition, it would not impact the asset price in the long term which is a buying opportunity for investors.

Wait for Confirmation

Always wait for confirmation because catching a falling knife is filled with risks as the direction cannot be determined. It is much safer to wait for confirmation as the prices have started to recover after reaching their bottom levels.

Demand and Supply Theory

According to the demand and supply concept, in falling knife, confirmation is determined when the prices reverse from the demand zones of the higher time frames and is able to breach at least one supply zone of lower time frames. If the price corrects by 30% or above in a few weeks, investing in falling knives can lead to negative returns.

This required traders to follow the advanced trend analysis to identify the trend reversal or continuation in the security. Moving average at different time frames can be quite useful to know the change in trend.

Risks in Falling Knife

It is important to take precautions while investing in falling knives because it can also even lead to bankruptcy can also be the ultimate outcome. Therefore, entry only after confirmation is preferred, investors should look for the reversal signals to ensure safe investing.

Even after the reversal, investors must follow appropriate risk management measures by understanding market dynamics and placing stop loss orders below the demand zone. If the price crosses the demand zones, it could negatively affect an investor’s portfolio.

The Endline

A falling knife is very risky to trade because of sharp sellers in the market. The prices do not follow the demand zones and continues to fall, in this case following the demand and supply approach is one of the best options as it guides properly about investing strategies.

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