The 2023 Guide on Falling Knife in Crypto Trading
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Cryptocurrencies have become an extremely popular asset class, and the burgeoning maturity of the industry has attracted institutional traders in droves. The resulting flurry of trading activity has brought mainstream trading concepts to crypto, including terminology such as “falling knife.”
Such terms and the messages they bring could be even more applicable to crypto than traditional assets because crypto is volatile. It’s utterly exceptional to have double-digit daily percentage gains and losses, even in the world of traditional assets such as equities. Still, seasoned crypto traders don’t bat an eye at such movements.
It’s therefore important to know the ins and outs of asset markets before getting your feet wet in crypto trading. So let’s take a look at what the meaning of “falling knife” is, and what you can take from the concept to improve your trading skills.
What is a Falling Knife?
A falling knife is used as a colloquialism to describe a quick, sharp drop in the price of a given asset or security. Given just how common such price movements are in crypto, the term is often bandied around.
It’s often part of the phrase “don’t try to catch a falling knife,” which cautions against a trader purchasing an asset as it declines rapidly for fear of that decline continuing and becoming even more dramatic. Instead, it runs contrary to advice such as “buy the dip,” although in both cases, the ideal situation is that the trader is able to enter a position when the price bottoms out.
Catching a falling knife is painful unless done correctly, in both the literal and trading sense. When a decline is referred to as a “falling knife,” it’s heavily implied that the price may continue to drop. However, falling knives can rebound just as quickly, especially in crypto. This rapid decline, followed by an equally rapid recovery, is called a whipsaw.
In traditional assets, the worst case for a falling knife is bankruptcy and the delisting of security. In crypto, plenty of projects fail and never recover, leaving “bagholders” in their wake.
For this reason, it’s wise to investigate the causes of a falling knife from both technical and fundamental perspectives, because this multi-pronged analysis may offer insight into whether it’s a dive to zero or a dip ripe for the taking.
What Does a Falling Knife Look Like?
Thanks to its cyclical behavior as it matured as an asset, Bitcoin is often cited as an excellent example when it comes to investing in falling knives. While the most recent down-trend hasn’t seen any sort of recovery to previous levels as yet, BTC did experience two significant falling knives in 2022, which can be seen in the picture below:
The somewhat less dramatic pattern in November 2022 in the above image demonstrates a falling knife that was an excellent entry point for longs. Investors who bought in throughout the month are sitting on a tidy profit.
Not all falling knives represent buying opportunities or recovery, though. Controversial trading platform Robinhood’s stock conducted an IPO in mid-2021, just months after playing a part in forced trading halts at the behest of clearing houses on the verge of collapse.
See the table below for more details:
Robinhood’s private investors and CEO were able to make a fortune as corporate media pumped the stock, but after the commotion ended, the ticker was left to its fundamentals. Exhibiting a series of falling knife patterns over the next months, it tanked into oblivion and has never recovered.
The Difference Between a Falling Knife And a Spike
A falling knife generally refers to a sharp drop in the price of an asset, and while it’s sometimes regarded as either fast or prolonged, there’s no specific duration to it. There’s also no real defined magnitude at which point a drop becomes a falling knife. Still, many traders and so-called analysts enjoy throwing out terminology when the chart looks dramatic enough.
On the other hand, a spike is generally used to describe a sharp, sudden movement to either the up-side or down-side. Spikes are generally caused by unexpected market events, but these can cause falling knives too.
Both a spike and a falling knife could lead to new norms being established for an asset, and previous prices may never return. However, Bitcoin has experienced many so-called falling knives in the past but always recovered as a new market cycle began.
Falling Knife in Crypto—Best Practices
Investing in assets that experience a falling knife pattern, or falling knife investing, is a strategy that’s high in both risk and reward.
Let’s take a look at some of the ways you can maximize your chances of profiting off falling knife candlesticks in crypto.
#1. Conduct Fundamental Analysis
There are many tools and tricks available to traders and plenty of ways to trade a falling knife. However, figuring out exactly why the security or crypto in question is plunging can help you refine your approach.
Let’s take Bear Stearns and Lehman Brothers stock during the Global Financial Crisis in 2008. Both companies’ stocks were being referred to as falling knives, diving toward bankruptcy and propelled by naked short selling. By analyzing these tickers, you couldn’t help but conclude that these weren’t falling knives worth catching.
#2. Conduct Technical Analysis
Technical analysis is another tool you can utilize, especially if your time frames are shorter and you’re not as interested in fundamentals. It’s possible to day trade or even scalp an asset that’s about to perish profitably using technical analysis, but you’ll need to move fast and use bots to help you out.
Technical signals like 52-week lows, volume changes, and trend reversals are often quoted when attempting to read a falling knife technically, and if you get it right, you can make a handsome profit.
#3. Employ Limit Orders
Limit orders are a good way to ensure that your positions are being managed within your risk tolerance and automated to perfection. Based on fundamental and/or technical analysis, you may think that you’ve identified the bottom of a falling knife—that’s where you place your limit order.
Then you have your limit sell order to take profit or exit the position if you’re not confident about a full or longer-term recovery. And finally, there’s the invaluable stop-limit order, which allows you to exit a position automatically at a predefined price if the asset begins to crash.
Though, if you’re trading stocks and not crypto, watch out for market makers engaging in stop-loss hunting thanks to Payment for Order Flow (PFOF) deals with brokers that allow them to see exactly what orders you’ve placed.
#4. Dead Cat Bounce
A dead cat bounce occurs when a falling asset reverses suddenly and seems to begin a recovery. Unfortunately for traders who think they’ve caught the bottom, this reversal proves short-lived, and the asset begins to plunge once again.
Dead cat bounces are quite common when it comes to falling knives since very few trading sessions see perfectly even movement in one direction or the other. A good way to identify a dead cat bounce is through fundamental analysis, and risk can be mitigated by using a stop-loss order to cut your losses after you’ve entered a position.
#5. DCA
Dollar Cost Averaging is a strategy normally used by long-term investors to accumulate an asset over a long period of time, even years or decades. This strategy is defined as buying a set dollar amount of the asset at a set interval, such as a $50 monthly Bitcoin investment.
You wouldn’t strictly DCA into a falling knife, but the strategy’s principle applies—it may be wise to enter with only a portion of your capital rather than all of it. That way, if the crypto in question keeps falling, you can buy in even lower with your next tranche of funds and average down on your position.
Again, though, fundamental analysis may dictate the feasibility of doing this. If the crypto in question is spiraling toward zero and has poor fundamentals, both the DCA and the YOLO approaches will result in the same worthless bag. The advantage of DCA is that you may be able to pull the plug without losing everything, and you stand to profit by a higher percentage if the play works out.
Risks Associated With Falling Knife
A falling knife isn’t a good thing, and the phrasing is particular in that it paints a cautionary picture. It’s rare that a dramatic tumble in the price of any sort of asset happens for no reason at all, and a falling knife tends to illustrate a very risky picture.
We’ll talk in detail about the risks associated with falling knives in the section below.
#1. Unknown Reasons
Unfortunately, figuring out what causes a crypto to fall is not always possible. If you’re reading this, you’re probably not an industry insider plugged into the grapevine, with all the juicy details just a quick call or text away.
Assets, including cryptocurrencies, can crash based on things that happen internally to the project, and the wider public is always the last to know. So while you’d think insider trading penalties would deter this sort of thing from happening, the big fish always gets away.
#2. Time Frame
If you’re in any way limited in terms of your time frame or simply prefer shorter horizons, entering a long position on a falling knife may not be for you. Sharp declines may not always be matched by equally dramatic recoveries, and you never know who may be doubling down on a short position and keeping the market depressed even if the fundamentals are good.
Therefore, catching a falling knife tends to be a strategy best suited to investors willing to employ a longer time frame and have the patience to wait until their position turns a profit.
#3. Crypto Market Cycles
Until 2021/22, many investors subscribed to various theories surrounding crypto bear and bull market cycles that revolve around Bitcoin halving. While there’s no telling if the theory continues to hold, the ill-timed arrival of a bear market could put the brakes on a falling knife from recovering.
Similarly, the entire market trending either way could force that particular crypto along in the general direction as well, halting or reversing the falling knife, kicking off a dead cat bounce, or deepening the drop.
Key Takeaways
The falling knife is used to describe the movement of a cryptocurrency or security, but by virtue of its name, it’s got a warning built-in. Catching a falling knife is an exercise in risk, and it can hurt—just like investing in a rapidly declining crypto can decimate your portfolio if you get it wrong.
However, done right, the falling knife can provide a great opportunity. It can offer lucrative entry points for a recovery or turnaround play, and as long as you do your due diligence, manage your risk well, and set your horizons out far enough, it can be highly profitable. If in doubt, as the advice goes, zoom out.
Falling Knife FAQ
Should you catch a falling knife?
You should catch a falling knife only if you’re sure there’s a soft handle to grab onto, and you’re wearing a chain glove. Meaning you shouldn’t invest in falling knife crypto unless you’ve done some analysis and are confident in your strategy. At the same time, mitigating risk via a stop-loss order is a great idea if your thesis is wrong.
What is a falling knife pattern?
A falling knife pattern can be seen on the trading charts when a crypto currency starts to tumble. It usually takes the form of one or more dramatic red candlesticks that take the asset price downward sharply.
When should I buy a falling knife?
You can consider buying a falling knife once you’ve identified the bottom, either through technical analysis, fundamental analysis, or both. Adopting the DCA strategy can mitigate some of the risks of buying too early.
If you think the crypto in question is on a one-way road to zero, you can also try to open a short position—just remember that the risk of short selling is infinite, and that’s why it’s mostly employed by hedge funds who gamble with other people’s money.