"Knife Catching" vs Buying a Dip: What's the Difference?

Ever heard the phrase "Don't try to catch a falling knife"? Catching a falling knife is a metaphor used in the stock market to describe the act of buying a stock that is rapidly declining in price, in the hopes of profiting from a rebound. However, this strategy can be risky and is often likened to catching a sharp knife that is falling, as it can be dangerous and result in injury.

The concept of catching a falling knife has been around for decades, and its origin is not entirely clear. Some sources suggest that the term originated in the futures market, where traders would try to catch a falling market by buying futures contracts in the hopes of profiting from a rebound. Others suggest that the term was first used in the stock market, where investors would try to buy shares of a declining stock in the hopes of making a profit when the stock price eventually rebounded.

Regardless of its origin, catching a falling knife has become a common phrase in the financial world and is often used to describe a risky investment strategy. While some traders and investors have had success with this approach, many others have suffered significant losses. In contrast, the legendary Warren Buffett once said savvy investors need to be "fearful when others are greedy, and greedy when others are fearful." At some point an investor/trader that wants to outperform the market will likely need to make purchases of a declining stock...so how do I do that and still avoid "catching a falling knife"? This article will focus on a few simple things to keep in mind before purchasing a stock, ETF, or futures contract in decline.

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Let's start by putting a definition to catching a falling knife. Truthfully, there isn't a standard definition, so let's create on in order to understand the difference between blindingly buying something and picking a logical entry. To me, knife catching means purchasing something at a price that has no apparent support right below the purchase price. In other words, there's nothing obvious that would cause price to stabilize or reverse course to the upside. Now, let's look at a few common technical analysis* factors that would likely support price from continuing to fall:

• Support & Resistance or Common Moving Averages

• Volume (by price)

• Options Activity

Support & Resistance or Common Moving Averages

I've lumped these 2 types of technical indicators together because they are essentially focused on the same thing: Key price levels that the majority of traders look at. What gives these things their power in trading/investing? The answer is trader psychology and basic auction theory. The more other market participants are looking at a specific indicator, the more likely the market will have a reaction in price. Let's look at an example:

Above we have a monthly chart of XLE (SPDR Energy Select Sector). We can see $77.25 has been a key Support/Resistance Level going back to 2007-2008. Now let's zoom in:

When we look at XLE from a Daily Candlestick perspective, we can see 2 newer upward-sloping Support & Resistance Lines. In this case, those bottom white lines have supported price nicely for quite some time. In recent months, XLE has declined roughly -20% from its recent highs. For many traders/investors, purchasing near $76 might feel like "catching a falling knife." I would argue that purchasing near $76 would be classified as "Buying a Dip" simply because of the multiple trendline supports that we can see on the daily chart clustered very close to each other. In this scenario, a trader/investor could make their purchase and set stoplosses underneath the trend lines near $75. If XLE were to continue its decline, the trader/investor could sleep easy knowing they attempted to buy a dip at a logical place with their risk defined based on strong past trends. For situations like this one, I personally think it's best to use a Daily Chart as that's what your average swing trader will be analyzing.

In contrast, let's take a look at KRE (SPDR S&P Regional Banking ETF). On the daily chart above, it's really hard to argue there's any technical levels of support for price at $43. In this scenario the best a trader/investor could do would be to place stoplosses below the recent lows; however, considering price has reached for fresh lows in 2 out of the last 4 trading sessions, this would be a high-risk trade. Could KRE bounce from here? Sure, it absolutely could, but sustainable trading is all about probabilities and at current price the odds of going higher seem equal to the odds of heading lower, which means the trader has no definable edge in this scenario (e.g. 50/50 coin toss).

Daily Moving Averages can work much the same way as Support & Resistance Lines, especially the most common DMAs like the 50, 100, or 200. Above we have a daily chart of Natural Gas Futures with the 200DMA. In the Green Bubbles, we can see where the 200DMA supported falling prices in the past. Just like Support & Resistance Line, DMAs can turn from providing support to providing resistance (Red Bubble) and it's important to be aware of this once price has pushed through a key area and attempts to return, but I digress. The real point of the chart above is to show the complete absence of any type of support near price right now, which could make purchasing Natural Gas a bit of a "knife catch" here. Could it rally? Absolutely, but it would certainly be a high risk trade without any technical support nearby.

Volume by Price

Traders/Investors can also use Volume by Price for clues that will help avoid knife catching.

Let's revisit the XLE daily chart. Above we have the daily chart with a Volume Profile (or Volume by Price) on the far right. This shows us where all of the volume has been transacted on XLE within the timeframe we're analyzing. The spikes that protrude farthest to the left are known as High Volume Nodes (HVNs) and the areas without spikes are called Low Volume Nodes (LVNs). A HVN shows us price levels that the market has historically been very active around. They tend to act as magnets over time, especially in indecisive markets: Price gravitates towards interest. Here we can see 2 very prominent HVNs inside the Value Area (the blue part): One near $77 and one down near $49.

Price tends to move quickly in Low Volume Nodes, largely because there hasn't been a lot of interest in the past at those prices. Remember earlier when I mentioned basic auction theory? That's where this comes into play. Considering the amount of buying near $77, we can reasonable conclude that some of those buyers would likely attempt to defend their long positions by buying more XLE between $68 and $77 if price were to lose the daily trendlines. However, under $68 opens a noticeable LVN, where the door opens for price to violently continue its decline towards the larger HVN at $49. You can think of these LVNs as "coin toss areas" where the market is forced to make a decision: Keep buying and defend longs or throw in the towel and liquidate? Buying in an LVN can be very lucrative for day traders; however, long-term swing traders/investors know if price is trading at say $63 it is just as likely to drift back up to $77 as it is to drift down towards $49 so it's probably smarter to exercise some patience and wait until price leaves the LVN to take a position.

Options Activity

With the recent rise in short-dated Options activity, the largest Put Option strike or largest Call Option strike have often been acting as "walls" for price, or a natural area of support based on market mechanics like dealer hedging. This phenomenon can also apply to longer dated Options interest but the example I'll show here is relevant for day trading. I took a long trade today at ES 3981 and one of our Discord members messaged me asking why I chose to "catch a falling knife" at that level. In their defense, here's the chart at the time of the trade:

On the 5min ES (S&P500 Futures) Chart above we can clearly see a rather aggressive selloff in the S&P500 and I'd agree that on the surface a long position here looks like a knife catch. But...

The 0DTE SPX GEX Chart above from https://twitter.com/rt_gamma shows a large Put "wall" at 3950, which is roughly 3980 currently on the front month ES contract I was trading. Since I can count on 2 fingers how many times price has meaningfully pushed through the large Put Wall so far this year, I chose to use this information as a buying opportunity, anticipating many of these aggressive options traders would be closing their now profitable 0DTE Puts, forcing dealers to buy back the shares they sold to hedge. (Note: Similar examples can be found shorting against the large Call Wall for the day) In this case the thesis worked, allowing me to "Buy a Dip" rather than "Catch a Knife":

Will this edge always work? Probably not, but nothing "always" works in trading and it's been an important new factor in my day trading that has been working with a high degree of success this year so I thought I'd include it to illustrate this article's main point:

If you're going to buy a declining financial instrument (stock, bonds, ETFs, futures, etc.) always do it with strong support RIGHT below you for the best Risk/Reward and results. As I've demonstrated, there are different types of support to consider but it needs to be something broadly recognized by other participants (i.e. Support/Resistance, Popular Moving Averages, Volume by Price) or something that's demonstrated a repeatable pattern (i.e. intraday 0DTE Option Walls). If you try to force a trendline when one really isn't there, you're asking for trouble. Similarly, stick to the most utilized indicators like the 50, 100, or 200DMA...other market participants are not watching your favorite obscure Moving Average but your Dentist probably knows where the 200DMA is.

In extreme circumstances like stock market crashes, any type of support for price is prone to fail, so it's important to be conscious of the broader market before buying any dip. There is no such thing as "perfect" when it comes to trading, but my hope for this article is to help you think about the most logical place for trade/investment entries when prices are falling. There's a big difference between buying something "in the middle of nowhere" and buying something very near a support level that's likely to produce a reaction in price or cradle price should it attempt to go down more. So before you buy something on a decline, ask yourself "Am I catching a falling knife or buying a dip?" There's a difference.

Happy Trading,

Horse

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*Note: This article focuses only on technical analysis instead of fundamental analysis. Many investors/traders will catch falling knives when they believe a company's stock is undervalued from a fundamental perspective; however, the market has demonstrated throughout the decades that overvalued companies can stay that way for long periods of time and undervalued companies can do the same. In my personal experience, valuation should be coupled with technical analysis when possible for the best long-term results.