Falling Knife in Crypto: Proven Buying Strategies

The term 'falling knife' is used in the cryptocurrency space to describe a continued and rapid decrease in the price of an asset. For many investors and traders, the first view of a red candle on a chart falling straight down can be terrifying. However, for the disciplined trader, a falling knife can present an opportunity to obtain a position at a large discount. The challenge comes into play during execution because if you attempt to catch the falling knife too early, you may sustain a large loss as the knife continues to fall.

Market Analysis Fundamentals

Falling knife definition: A falling knife is not simply a corrective move in the market; it is characterized by a dramatic decrease in the price of a security, generally caused by panic selling, liquidations, or fundamental news. The crypto markets are inherently volatile, and in these types of events, you can see price declines of double-digit percentages in just a few hours.

Market dynamics: The market dynamics surrounding a falling knife are often the result of a feedback loop of sorts. When prices fall, the number of leveraged positions increases (forcing positions to be liquidated). This creates more selling pressure on the security (or stock), which in turn creates a further drop in price.

Risk identification & Opportunity assessment: Understanding how to establish the pulse of the market at the time is critical for correctly identifying risk. You will not simply be searching for the lowest possible price; rather, you will search for the point at which traders are exhausted from selling and will begin to purchase due to increased demand.

Strategic Rules

In order to trade a falling knife pattern, you will first need to determine whether the move is merely a temporary drop in price, or whether it is a sign of a structural trend reversal. The following three rules can help you remain safe while trying to obtain a position in a falling knife.

Temporary vs structural: Understanding Structural or Market Based Drop: If the drop on a project is based on negative market news (like a hack), then you want to know that information is causing broader sell-off from the market. A structural failure is also rarely a reason you want to catch.

Market psychology: Understanding Market Psychology: You generally want to wait for capitulation before catching the falling knife. Capitulation (The point where the last remaining bulls have given up and sold out) usually occurs when there is a huge volume of trades at the bottom of a major drop in the stock charts, or crypto pair.

Technical timing: Understanding Technical Timing: You never want to buy any stock or coin just for the fact that they're cheap, you want to wait on the market and then watch for signs of a potential rebound.

Risk Management

Entry timing: To succeed in catching a knife that continues to fall, you need objective data points used by technical traders to protect themselves from emotional decisions. Many technical traders will use the following tools:

• Relative Strength Indicator (RSI): this will provide a buy/sell indicator based on whether or not the price of an asset has become overbought (an asset is highly valued and selling will likely continue) or oversold (the asset price was valued at one time and will be valued again in the future); during the falling knife timeframe the RSI will likely read less than 30 - indicative of a strong downward momentum, however you're waiting until the RSI begins curving back-up before purchasing.
• MACD - moving average convergence/divergence: Look for bullish crossover on the MACD. If the MACD is on an uptrend, it will likely show up on a chart when you are near the current lows, indicating that the falling knife is losing momentum.
• Support Levels: Identify historical chart patterns where the price has once fallen; price being met with buyers; when a security breaks-through a major support level, the next major support level above will be the first potential target for attempting to catch that falling knife.

When you're trying to catch the bottoms of markets, risk management is something that can never be compromised. A trend that is considered to be moving downward has the potential to be very dangerous and can also lead to "whipsawing" on the market resulting in losses to your trading account as quickly as they begin.

Position sizing: Do not "go all in". Instead, have 3 or 4 separate entries into your trade. This trading technique is called scaling into a position.

Stop loss placement: Place a hard stop loss just below the last swing low price. If the stock is a rapidly decreasing stock or crypto and it continues to decrease, then your short position or exit plan will need to go into effect as soon as that happens to limit the range of loss on that trade.

Exit strategy: As part of your execution, having a predefined plan for when the momentum shifts is essential for protecting your capital.

Mental preparation: Be prepared for the fact that you may lose your first trade. The goal is to identify trends and not be perfect.

Implementation Guide

If you're looking to traders to navigate through these wild swings, they will need to have a strict implementation plan/checklist.

• Signal identification: Look for a stock that has rapidly dropped and has had an increase in volume suddenly.
• Entry criteria: Look for signs of stabilization or trend reversal. A sign could be a hammer candlestick pattern from a daily chart or a support level created by a long-term moving average.
• Trade management: As soon as your trade is active, you need to move your stop loss to break even once the price has moved into your favor.
• Exit planning: Do not get greedy. Target the first major resistance level (usually the 20 day index or EMA) as your primary target profit level.

Market Context

Spike vs knife differences & Historical examples: It is very important that all of us understand what the differences are between a falling knife and a typical dip. Historically, economic data releases or poor financial performance coincide with drops in stock prices. For example, when reviewing the S&P 500 or Nasdaq, you will find larger-than-normal drops associated with financial results that fall short of analyst expectations or when recessions are occurring.

Pattern recognition & Success factors: When the market is highly volatile, the market moves rapidly upon news, creating what's considered a "false" bottom. An easy way to avoid being whipsawed is to wait for a few candles on higher time frames (4H or Daily) until you see signs of stabilization before making your entry decision.

Conclusion

Catching a falling knife (in crypto) can be one of the most profitable yet riskiest ways to invest; the value of an asset could drop significantly, yet as quickly as it dropped, recovery will occur. Key to the success of this type of trading is charting and utilizing technical analysis, strict risk management techniques, and being patient enough to let the price action prove that the asset has reached its low point (bottom). By utilizing an orderly approach to entering and exiting a trade, turning an asset that is declining into profit-generating trend reversals.

FAQs

How to differentiate between temporary dips and a sustained fall (downtrend)?
Review the volume and economic news. A temporary dip will typically have lower volume than the overall volume for that instrument price and little to no fundamental negative change. Most often a sustainable downtrend or a falling knife will have higher volume than the overall volume and usually will be the aftermath of significant economic impact news or negative news events.

Which technical indicators are best to identify possible market bottoms?
The MACD (Moving Average Convergence Divergence) and RSI (Relative Strength Index) indicators are the two most reliable indicators. Look for bullish divergence, i.e., where the price makes a lower low, and one of the above indicators makes a higher low.

How to calculate the proper position size in a falling market?
Risk no more than 1-2% of your total capital per single "knife" trade; consider increasing position size gradually, not all at once.

What is the role of market sentiment in determining when to catch a falling knife?
Market sentiment switches typically lag behind the market price change. The lowest point of the market is usually associated with the highest fear level in the market; once social media is really bearish, it is very likely that the falling knife will rebound from the bottom.

How to manage your risk when attempting to catch a falling knife?
Always utilize a stop loss order for each knife trade; because a falling knife will refer to a momentum trade, if the support levels fail, the asset will continue to fall; therefore having an active stop-loss protection in place is crucial to preventing a catastrophic loss in your equity.