What is a Falling Knife?
The falling knife chart pattern is a technical analysis term used to describe the situation where an asset's price suddenly drops sharply in a short period of time. This pattern is often seen when a stock has experienced a rapid decline due to weak fundamentals or market sentiment, and investors are attempting to buy it at the bottom of the movement. The sharp downturn creates a “knife” shape on the chart, with the handle representing the sudden drop and the blade showing further downside potential if buyers are not able to absorb all available shares before prices rebound.
Although this chart pattern can be seen as an opportunity for some investors to buy cheap stocks, it also carries high levels of risk that require careful consideration before taking any action. Investors should familiarize themselves with the underlying fundamentals of a stock before attempting to identify any plausible falling knife chart patterns. This is because the pattern may be an indicator of further downside risk and it is important to have a thorough understanding of the stock’s risks and rewards before committing any capital. Additionally, investors should implement strict stop-loss orders as part of their trading strategy in order to limit potential losses in case prices continue to move lower. All in all, the falling knife chart pattern can offer some unique investment opportunities for those willing to take on its risks; however, proper research and caution should always be exercised when considering this type of trade.
Simplified Example
A falling knife is like catching an apple that is falling from a tree. If you try to catch the apple when it is still falling, it can be very dangerous because you don't know which way it will land. But if you wait until the apple has hit the ground, it is much safer to pick it up. Similarly, if you try to buy a stock when its price is still falling, it can be risky because you don't know when the price will stop dropping. But if you wait until the price has stopped falling, it may be a better time to buy the stock.
History of the Term "Falling Knife"
The term "falling knife" is employed to characterize a swift and substantial decline in the price of a security or asset, frequently within the realms of stock markets and cryptocurrencies. Its origin is believed to trace back to the early days of stock trading, where traders used knives to carve notches into wooden boards as a means of tracking stock prices. In instances of rapid stock price declines, it became challenging to carve notches rapidly enough to keep up with the descent, often resulting in the knife slipping and falling. This analogy gave rise to the term "falling knife" to depict a stock price experiencing a precipitous and rapid decline.
Examples
Apple Inc.: The tech giant saw a sharp decline in its stock price from 2012 to 2013, following news that the company was struggling with declining demand for its products and increasing competition from rivals. This pattern of rapid decline earned it the nickname “the falling knife” among traders.
Vale SA: The Brazilian mining giant, which is one of the world's largest producers of iron ore and pellets, saw its share prices plummet more than 80% between 2011 and 2016 due to weak global demand for commodities, as well as political turmoil at home. As a result, it gained notoriety as an example of a falling knife pattern.
Yahoo!: Investors were caught off guard in 2015 when Yahoo! drastically slashed its core business and announced massive layoffs. This resulted in the company’s share price falling more than 50% overnight, becoming an example of a typical falling knife pattern.