Picture yourself in the kitchen slicing an avocado, then, all of a sudden, your dog lunges for the delightful berry and knocks the knife right out of your hand! What do you suppose your instinctive reaction would be? Do you dive out of the way to avoid getting cut or reach for the knife to try and catch it before it hits the ground? Well, unless you have the agility and reflex speed of a cheetah, there’s only one correct answer; get the hell out of the way!
Now, take that same scenario, only this time, apply it to your favorite futures or forex product. When the markets are tanking, the first reaction a lot of traders have is to try and pick a bottom, when in reality, they should be backing away until a base has formed. This week, the Topstep coaches dive into best practices to avoid getting run over in a violently trending market.
Here’s What Our Coach’s Have To Say
Funded Trader Shout-Out!
Sticking to the current theme, this week’s Funded Trader shout out goes to another Nasdaq trader. Rather than trying to catch the falling knife, Brent S. found himself on the right side of a big down move and raked in an impressive $4,800 trading day. Brent’s big day is an excellent example of recognizing what type of environment you’re trading in early on and taking advantage of it.
What is a Falling Knife?
You can best describe a falling knife circumstance as a speedy or violent drop in price with very few pullbacks or opportunities to enter a short position or exit a long position at a better price. When you hear someone talking about “trying to catch a falling knife,” you can assume they were attempting to pick bottoms and continued to buy the market on the way down.
There are no set parameters for how long or far a market should move to be considered a falling knife, but many professionals will say that a 1% move within a specific timeframe will constitute one. Volume is also an essential factor to keep in mind; when panic sets it, you want to see a significant spike in volume. So, along those lines, it’s fair to say that all falling knives happen on trend days, but not all trend days are falling knives.
What Does It Mean?
In a word, a falling knife represents panic. Momentum has rapidly shifted to the downside, and traders are racing to either cover their long positions or enter short positions. As bids dry up and more offers continue to pile in, the market picks up speed and begins to break faster and faster.
Eventually, the bottom falls out, and all of the under funded and over-leveraged traders that took a shot at catching the falling knife get sent packing.
Keep a close eye on the events that led up to the fallout too. If you have a good pulse on the fundamental factors that forced people into a panic, you should also be able to gauge how long the recovery will take. Doing this kind of analysis is a great starting point for putting together your strategy for a trend reversal.
2020 has provided plenty of opportunities to learn how to trade highly volatile markets, and hindsight is always 20/20. Even so, when the dust settles, it’s apparent that it makes little sense fighting the tape. Unless you have the capital to risk taking a few big hits, your best bet is probably to take a seat and wait out the move.
The big down moves don’t last forever, and big up moves usually follow them. So stay patient and diligent, and wait for the market to do its thing. When you’re confident that a bottom is forming, take your shot and try to ride the wave back up.