# Understanding Falling Knives: Risks and Strategies for Investors

## What Is a Falling Knife?

A falling knife describes a sudden price drop in a security, often serving as a cautionary term for investors. While entering a downtrend can be risky, recognizing potential profit points through strategic timing and technical indicators can mitigate loss and maximize gains. Traders need confirmation of reversals before diving in, avoiding premature decisions in volatile markets.

### Key Takeaways

*   A falling knife describes a rapid and sharp decline in a security's price, which can be risky for investors trying to time the market.  
    
*   Traders are advised to look for confirmation of trend reversals through technical indicators rather than attempting to catch a falling knife blindly.  
    
*   Falling knives can present profit opportunities if timed correctly; however, they also carry significant risks and can result in losses.  
    
*   Common causes of falling knives include negative earnings reports, poor economic indicators, technical breakdowns, and fundamental issues with a company.  
    
*   Although a falling knife can signal a buying opportunity, it's crucial to understand the context and confirm a stabilization or recovery before investing.

## Understanding the Risks of a Falling Knife

The term falling knife suggests that buying into a market with a lot of downward [momentum](https://www.investopedia.com/terms/m/momentum.asp) can be dangerous, just like trying to catch an actual falling knife. In practice, however, there are many profit points with a falling knife.

A trader who buys at the bottom of a [downtrend](https://www.investopedia.com/terms/d/downtrend.asp) can realize a significant profit as the price recovers if it's timed perfectly. Likewise, it can be profitable to pile into a short position as the price falls and get out before a rebound. Even buy-and-hold investors can use a falling knife as a buying opportunity if they [have a fundamental case for owning](https://www.investopedia.com/why-legendary-fund-manager-bill-gross-does-not-advise-you-to-buy-the-dip-11790388) the stock.

But many traders still pay lip service to the falling knife adage because there's a very real risk that the timing will be off, and there could be significant losses before any gains are realized. Traders should look for confirmation of a trend reversal using other technical indicators and chart patterns instead of trying to "catch the falling knife." 

Confirmation might involve waiting for several days of upward momentum or checking the [relative strength index (RSI)](https://www.investopedia.com/terms/r/rsi.asp) for a strong uptrend before buying.

## Strategies for Trading a Falling Knife

There are several ways to profit from a falling knife. Many of the trading approaches are time-sensitive and require more tools than simply identifying a stock that's seeing a sharp drop. A fundamental case for catching a falling knife can be made depending on the reason for the drop.

There are many potential causes for a falling knife to occur, including:

*   **Earnings reports:** Companies that report their earnings are often subject to [volatile swings](https://www.investopedia.com/terms/v/volatility.asp). The stock may become a falling knife until the market reaches an equilibrium if the financial results are lower than expected.
*   **Economic reports:** Major indexes are often influenced by economic reports such as employment reports or [FOMC](https://www.investopedia.com/terms/f/fomc.asp) meetings. Stocks can move sharply lower in response if these reports are negative.
*   **Technical breakdown:** Some falling knives occur due to technical rather than fundamental factors. The price can move sharply lower before finding support if a security breaks down from key support levels.
*   **Fundamental deterioration:** This occurs when the company underlying the stock badly misses on a key performance indicator like sales or earnings. It can also happen when companies are found to be doing something fraudulent or suffering damage in the media.

A falling knife might be a buying opportunity if the causes are temporary or don’t change a long-term investment plan. It's difficult for traders and those with a shorter timeframe to time bullish trades correctly.

## Case Study: Navigating a Falling Knife

The following chart shows an example of a falling knife and demonstrates the danger of trying to predict a bottom.

![Image](https://www.investopedia.com/thmb/CMwZXCXnYuyxkpfXcV4xl4HD0y8=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/dotdash_Final_Falling_Knife_Jun_2020-01-e909c7a603314eceabbd1292cc5085dc.jpg)

**

The stock turned into a falling knife after moving away from its 50-day [moving average](https://www.investopedia.com/terms/m/movingaverage.asp). Traders buying in at $8.50 might have seen a brief pause in selling, but then lost money as the stock fell to $6.00 before bottoming.

> **Important**
>
> Traders who waited for confirmation could have benefited from the move from $6.00 to $10.00 in the ensuing month.

## Comparing Falling Knives and Price Spikes

A falling knife is a sharp drop. A similar type of trading slang is a spike, which refers to a sharp movement in price action either up or down. But a spike is most often associated with an upward movement in practice.

## Challenges and Limitations of Trading Falling Knives

A sharp fall can often present an opportunity. Many of these require some form of confirmation, such as a [moving average convergence divergence (MACD)](https://www.investopedia.com/terms/m/macd.asp) indicator showing positive divergence. A falling knife is an ill-defined chart formation at best. It's not the most significant part of a trade playing off a breach of support or a true reversal.

## What Is a Whipsaw in Trading?

A [whipsaw](https://www.investopedia.com/terms/w/whipsaw.asp) occurs when an extreme movement in price is directly followed by a sudden and equally extreme reversal. It's the result of a highly volatile market when signals can be misleading.

## What Is the Relative Strength Index?

The relative strength index measures the size and speed of changes in the market. It ranges from zero to 100 and the score is an indicator as to whether the index is overbought or oversold. It's considered to be overbought at 70 or above or oversold below 30.

## What Is Moving Average?

Moving average is an indicator of the average price of a security over a predetermined period. It's a lagging indicator because it looks at fluctuations that have already occurred but it can identify trends and momentum.

## The Bottom Line

A falling knife refers to a rapid and sharp decline in a security’s price, serving as a caution against hasty investment decisions during such downturns. While trading opportunities exist—like profiting from a price rebound or short positions—caution is advised.

Effective strategies include confirming trend reversals through technical indicators instead of attempting to predict market bottoms. Investors should evaluate whether the factors leading to the drop are temporary and part of an informed buy-and-hold strategy. Ultimately, navigating a falling knife requires due diligence and strategic timing.

_The comments, opinions, and analyses expressed on Investopedia are for informational purposes only. Read our [warranty and liability disclaimer](https://www.investopedia.com/legal-4768893#toc-warranty-and-liability-disclaimer) for more info.  
_

> **Article Sources**
>
> 1.  U.S. Bureau of Labor Statistics. "[Consumer Price Indexes Overview](https://www.bls.gov/cpi/overview.htm)."
>     
> 2.  Market Business News. "[Whipsaw—Definition and Meaning](https://marketbusinessnews.com/financial-glossary/whipsaw-definition-meaning/)."
>     
> 3.  Fidelity Investments. "[Relative Strength Index (RSI)](https://www.fidelity.com/learning-center/trading-investing/technical-analysis/technical-indicator-guide/rsi)."
>     
> 4.  TradingView. "[Moving Averages](https://www.tradingview.com/support/solutions/43000502589-moving-average/)."