What Is Falling Knife In Crypto Trading?

Summary:

• A falling knife is a term used in investing or trading to describe a crypto or stock that looks like a good buy because its price has fallen significantly.
• Buying an asset when its price is plummeting is dangerous, just like trying to catch a falling knife.
• This is because even if an asset seems to be “on discount,” it may depreciate even more or become completely worthless.

What Is a Falling Knife?

A falling knife refers to a stock or crypto that is plummeting in value. There is no definitive number, but it generally refers to an asset that has rapidly dropped more than 20% from its 52-week high.

The full metaphor–”to catch a falling knife” is used to warn traders and investors not to be rash in buying into an asset just because its price has fallen and thus appears to be cheap. Buying into a plunging market can be extremely dangerous—just like trying to catch an actual falling knife.

The reason: just because the price has fallen by 30% to 50% initially, this does not mean it cannot fall another 80% from this lower price. 

During the 2000 dot com bubble, traders bought into stocks of internet startups when prices fell by over 50%, as they thought they were getting a great deal. Not long after that, many of these stocks went to zero.

Traders and analysts are always asking, “Is the bottom in?” Catching the true bottom price is the holy grail for all traders – it is an extremely tricky task that even experienced traders find hard to do well all the time, but highly rewarding if they can.

How A Falling Knife Pattern Looks Like

(Source: Phemex Testnet)

The falling knife pattern often forms after a large price move to the downside, and it will look like a sharp price move on a trading chart that goes straight down with no consolidation or pause. As shown above, a falling knife pattern is formed by a consecutive series of long, bearish candlesticks.

Read our guide on the 8 most important candlestick pattern before you start trading.

The Bitcoin Falling Knife

Inexperienced traders believe that a falling knife crypto offers an opportunity to buy a coin at a discount. One common mistake they make is buying at the next immediate support line without watching the price action closely enough. This is because if the price breaks below support, it will likely continue to fall until it finds new support at lower levels.

A good example of this was in April 2022, when Bitcoin plunged from $45,000 to $39,000. Some traders would view this as a chance to buy Bitcoin on the cheap. A month later, it fell by another $10,000 to below $30,000. Just a few days later, it fell below the $20,000 level. At time of writing, Bitcoin is hovering around this $20,000 level but some analysts believe if it does not hold this level, it will fall to $12,000 – the next support to look out for.\

Bitcoin falling knife from earlier this year (Image source: Coinmarketcap)

Falling Knife Crypto Investing Tips

Falling knife investing is a high-risk, high-reward strategy that can be very profitable if done correctly. It requires a great deal of patience, discipline, skill and market intuition. Here are some tips to catch a falling knife without getting cut.

• Use technical analysis by watching for these signals: 1) when the coin has reached a new 52-week low 2) when there is a drastic increase in volume, and 3) when there are signs of price recovery or trend reversal. This means that the selling pressure has subsided and the stock or coin is unlikely to fall much further.
• Watch out for the dead cat bounce: This is when the price falls rapidly and then suddenly reverses and starts moving higher. However, the move higher is usually only temporary, and the price will continue falling. This can be a trap for investors who think that the price has found a bottom and start buying.
• Dollar-cost average (DCA) your way in. It can be extremely tempting to buy all at once when you see a coin’s price fall by 50%, but this can be a grave error, because just because a coin’s price has fallen by 50% doesn’t mean it can’t go down another 50% or 60% from there on. Buying gradually helps ensure that you still have funds to buy in when prices dip even lower.
• Use stop-loss orders and limit orders to manage your risk exposure; these help to limit your losses if the stock continues to fall.

The falling knife investing strategy is a great way to catch what is typically a once-in-a-lifetime opportunity in the market. Still, it is important to remember to use it with caution and not to risk more than you are comfortable with.

Don’t Try To Catch A Falling Knife When…

• You don’t know the reason behind a price depreciation of a stock or crypto.
• The reason behind the price depreciation is company-specific i.e. an internal scandal, controversy or mission-critical technological setback, because this means price is unlikely to rebound anytime soon. In this case, no matter how cheap you buy the coin for, you will suffer a loss.
• You have a short-term investing horizon. Falling knives are better suited for long-term investors with a high tolerance for risk, who can ride out the volatility to ensure a profitable trade.

Limitations of the Falling Knife Investing Strategy

Falling knives strategy is not without its limitations. One of the biggest problems with this strategy is that it can be very difficult to perfectly time the bottom i.e. the lowest price a stock or crypto will fall to before it trends up again. Even if you are able to identify all the criteria for falling knives, there is still no guarantee that the price will not continue falling. This is why it is important to apply stop-loss orders when using this strategy.

Another limitation of this strategy is that it can take a long time for the price to start moving higher. This can be frustrating for investors who are waiting for the price to start moving in the right direction.