In technical terms, catching a falling knife refers to buying a cryptocurrency that is rapidly selling off. The steep decrease in the price makes this trading strategy very risky, but at the same time, if done correctly, it can yield massive returns.
What is a Falling Knife in Crypto?
In the financial industry, a falling knife is a stock/crypto or any other asset that has been in a strong downtrend and is trading at a fresh low.
The analogy comes from the fact that it’s very hard to catch a knife that is falling without getting hurt. The same concept applies to cryptocurrencies.
Below are 3 rules to abide by if you want to buy cryptocurrencies right at the bottom.
Rule #1 Temporary Headwinds Or Structural Issues
The first rule is to look at the overall market trend and analyze if the sell-off is due to temporary headwinds or if there are structural issues. For example, the Bitcoin sell-off due to China’s crypto mining ban in May 2021 was a temporary headwind.
Bitcoin’s rapid sell-off was short-lived, and the cryptocurrency bottomed right on that day. So, buying a falling knife in this scenario was the smart thing to do.
Rule #2 The Crowd Tends to Overreact
In the short term, when there is an overreaction in the market, we tend to get a bounce. Richard Thaler, Nobel Prize winning economist, showed that if we take higher risks, in the long run, it will lead to higher returns.
Rule #3 Lower the Time Frame
Lastly, make sure you lower your time frame to an intraday chart to have a better idea of when the price is about to reverse.
An easy way to time the reversal is to wait for the final flush to the downside, which will usually be a big exhaustion candle with a big wick and then a confirmation candle that reverses the most recent selling pressure.
How risky can a Falling Knife be?
Catching a falling knife is very risky because if you buy at the wrong time, you can get caught in a vicious cycle.
As the price keeps going down, you keep buying more because you think the price can’t go any lower. But eventually, you’re left with a large bag of crypto and the price keeps going lower.
If you can’t handle the mental stress of a falling knife, then you’re better off not catching it.
The Difference Between a Falling Knife and a Spike
A spike is a sharp move to the upside that is usually due to a strong catalyst. A spike can also be a move to the downside due to an unexpected event.
The difference between a spike and a falling knife is that a spike is a sudden move due to a market event, whereas a falling knife is a prolonged downtrend due to bad fundamentals. For example, Bitcoin’s move from $20k to $3k was a falling knife.
The bottom line is that when you see a sharp move to the downside, it’s usually an opportunity to buy a cryptocurrency at a discount. But make sure you follow the above-mentioned rules to avoid buying the falling knife too early. Above all, don’t buy the falling knife if you can’t handle the mental stress.
