«Catching a falling knife» — this expression describes a situation when a trader tries to buy an asset (currency, stock, futures, etc.) at the moment of a rapid fall in its price, hoping the price will rebound or reverse. The term is often used in expressions such as «don't try to catch a falling knife,» which can be translated as «wait for the price to bottom before buying it.»
Why is it not recommended to «catch a falling knife»?
- When the price is sharply falling, it means that numerous sell market orders are coming into the market, which is more than buys. This is a supply-side imbalance. And until the price reaches that support zone or pocket of liquidity where the reverse imbalance occurs, the fall will continue.
- Statistically, with a «falling knife» the price makes 1-3 additional downside breakdowns. In this case, the probability of the continuation of the downside movement is 70-80%, while the probability of a rebound is only 20-30%.
- With a «falling knife», the trader opens positions against the trend, while it is better to always trade within the trend rather than against it.
- When a trader buys a «falling knife» and the price continues to decline, the trader begins to buy further down, averaging his entry price and increasing the risk of losing money. In this case, the trader begins to rely not on trading strategy but on luck, expecting that the size of the deposit will be enough to withstand the drawdown.
- Oversold prices, as well as overbought prices, are only suggestive zones where the price may reverse, but no one knows how big this zone may be. Moreover, according to some investors, there is no such thing as «price too high» or «price too low.» Everything is decided by market sentiment, expressed in the number of open positions at a current price level. Neither the market maker nor the retail traders know where the market sentiment will change.
Visually, the buy trades during the «knife drop» look something like this:
Why do traders even try to catch the knife?
- Trying to enter the market at the lowest point, as they think.
- Confidence that the price is too oversold.
- Greed.
«Catching a knife» is like trying to stop a speeding train. It is highly not recommended to open long positions during an impulsive downward movement. But it is very difficult for traders to prove otherwise.
That is why we decided to give some tools that will help traders to «catch the knife» in places where the price can rebound with high probability:
-
The POC (point of control) of the day or week — the maximum volume zone of the day or week.
Example:
-
Liquidity voids or fair value areas.
Example:
-
Pockets of liquidity beyond the minimum of a day, week, month, or year.
Example:
-
The maximum volume of the day or week in the tail of the candle. This indicator works best with the volumes of futures instruments. For example, you may be watching Nasdaq (NQ) or Gold (GC) futures and trading US100 or XAUUSD on Forex, respectively.
Example GC:
Example XAU/USD:
-
Divergence on both MACD and RSI indicators.
Example:
-
Drop-Base-Rally area — this is the zone, where earlier there was a change of market sentiment towards purchases.
Example:
It is best when these factors complement each other. The more coincidences in one zone, the better.
It's generally recommended for investors and traders to exercise caution when considering «catching a falling knife.» It's crucial to conduct thorough research, analyze the reasons behind the price decline, and consider the overall market conditions before making any investment decisions. Diversification and risk management are also important strategies to mitigate potential losses in the volatile financial markets.
Have a good trade.