Wednesday, April 28, 2010

The Daily Note - The Falling Knife

Falling knives do not occur as frequently as many traders think. It's probably because of definition that we don't necessarily agree with or understand. In my opinion falling knives happen when there is a long, upward trend when many people are lulled into the steady skyward heading of the market and forget about the downside.

We tend to forget not because of being stupid, we forget because we get comfortable and cozy with our confidence of the market's trend. We also forget because there already have been a few pullbacks where traders may have bailed only to see the market again continuing the uptrend. It is also reinforced by the continual happy news and the lack of reaction to the not so good news. In other words, the market shakes off more and more any worry about a possible serious reversal, despite the longevity of the trend or evidence of history.

When the reversal happens, because of the aforementioned comfort, traders at first believe the reversal will be short lived and therefore will hit bottom within a short period of time, so they try to time its bottom so they can again be in the comfort zone of the climb. Therefore they buy on the pullback and when it fails they get stopped out.

One stop will not make a serious impact about the seriousness of a reversal, where eager bottom fishers are willing to take chances. It will take many and a series of stops for most traders to be finally convinced to the contrary. It is the participation of many traders in a continued attempt to time the reversal bottom which creates the falling knife, because there are many sellers wanting to take profits fearing a meltdown.

Falling knife trading requires eager buyers looking for a bargain and panicked sellers looking for the best possible top caught holding profits during serious pullback. Bargain buyers are met shortly with panicked sellers, who then follow the buyers down to a lower low where the eager bottom fishers are waiting to drive the stock back but always to be met by sellers now willing to sell at a lower top. So the frenzy continues until... the buyers go away bleeding and the last seller was driven to sell at the worst perceived low.

How do you avoid the falling knife? Trust your stops and when you observe that more than one stop has occurred, sit it out. Wait and watch and don't be too eager to re-enter until the frenzy has abated. Only then should you check your charts for the next pattern. As a friend so often has told me: winners are not the bottom buyers or top sellers, winners reside in the 60% in between.

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