The Dangers of "Catching Falling Knives" in Bear Markets
Should you buy the dip in a bear market? If so, when and how? - Market series
Don’t be a hero and don’t fight the trend!
We’ve already concluded that short time frames, while still favoring the trending side, can be exploited by counter-trading on the short bounces. Again and I really do have to keep hammering this point across, risk management is paramount!
Catching knives
The reason for the name is a glaring one - you’ll get cut if you do.
The metaphorical act of catching falling knives represents the attempt to buy during panic dumps in a bear market. This strategy, although alluring, comes with inherent risks. Understanding the dangers involved is essential before embarking on such a venture.
The biggest problem with catching a falling knives is managing risk.
If you can, try to avoid this type of trade, especially in bear markets, as they are riddled with problems.
Uncertainty about the extent of price drops and the duration of the downtrend. Anything is possible in the market.
Difficulties in setting up tight stop-loss orders due to market volatility. Lack of a reliable structure for placing stop-loss orders, increasing the risk of immediate stop-outs.
Going against the prevailing trend, leading to unfavorable odds of success.
Poor risk-to-reward ratio for this type of trade.
What usually happens is that the lower the price goes, the more attractive it appears and the more we want to buy. We keep doing that until we run out of money. Trapped underwater, we pray to our benevolent Gods for mercy. This is a trap!
The first rule of catching knives is - never catch knives, and the second rule of catching knives is, if you do decide to test your luck, do it with minimal size!
Stops, as we’ve already mentioned are practically impossible in any proper attempts at buying full-blown panic dips, so position sizing is the only real tool left.
Since you cannot set up a smart stop loss position, you have to bet small. Remember the odds are against you on this one and you’re as unprotected as a baby rabbit in a den full of hungry wolves. When you are buying the dip in a bear market, without the protection of a stop-loss order, you are effectively exposing your whole position or account to risk!
It’s not exactly a “safe bet” in bull markets (buying the dip), but it’s a suicidal bet in bear markets!
If you still choose to play, play small. In this case, even if you lose it all, you’ll be hurt, but you’ll live.
Everybody has their own risk appetites and financial stories, but risking everything on buying the dip - catching a falling knife - is a recipe for disaster. I would know, it was my Modus Operandi in my first year of trading.
I would suggest going in slowly, in steps, or layers.
Decide upfront on your maximum desired position size (for example 10,000 USD), and split that position into smaller orders. A few ways to go about this:
SIMPLE: Orders in equal sizes (2,000 USD x 5 orders, for example) or
OPTIMIZED: Start with smaller ones first (500 USD) and then increase the size (1,000, 2,000,…), thereby lowering your average price as the price goes down.
SMART: Only add to your position as the price bounces and your initial position is in profit, adding on the way up.
Be very conservative, expecting the worst possible scenario. It’s much better to only fill half of your orders than to fill them all and watch as the price goes down for another 20% or more. Don’t be greedy.
Never go over innitially (before entering positions) decided upon position size!
Not a penny more, no matter the temptation and I assure you, if the price dips another 10 or more percent, the temptation will be monstrous! Think of staying abstinent in a house full of horny supermodels, all simultaneously on you like hot female Vulcans in heat! (Star Trek joke for the fans out there)
This one thing, buying the dip and buying more on the way down, especially in a bear market and not getting out the first chance you get, is the true killer of men, the destroyer of dreams, the liquidator of accounts. That and leverage of course.
Buying more and more as the price goes down, is responsible for more than 90% of all liquidations and portfolio disappearances. Ok, so I made the number up, but it’s still true, I think, probably, definitely - look, just don’t do it, because you’ll lose all our money if you do. Especially if you trade with leverage.
There is a reason many traders, myself included, have a very important rule in our trading rulebook, written in red and in bold letters with a reminder to remember the pain of past transgressions (and losses).
Never add to losers, only ever add to winners!
It’s smart to always have some free “bullets” (money) to buy lower on the dip. This way you are happy no matter what the price does. If it goes up, you’re making money. If it dips lower, you can buy more. But only until you reach the accumulated position size you have determined to risk on this trading idea!
If you end up in profit on your knife catch, you should then start thinking about how to protect your position.
You can protect it by:
Placing a stop order below the last price low (the tip of the dip).
Placing a stop at your brake even point, if your position is already well in profit.
Selling some of the position on the first bounce.
Bullish bounces in a bear market tend to be short-lived, so take profit quickly and don’t be greedy, waiting for some large pump. In bull markets the story is different. There the continuation of the trend is expected so holding trades longer makes sense. In bear markets the trend is down and the odds are that it will continue further.
These types of trades are the so-called “hero trades”. Buying the bottom of a bear market and riding the following bull, making “mad gains”. Great for bragging about if you actually pull it off (most are just larpers), but in reality most attempts end up on the dark memorial pages of liquidated, fallen soldiers, now moving back in with their mommies and scrolling the classifieds for a job.
In case I haven’t been clear on this, here’s a recap:
Never catch knives in a bear trend (buy big dips) and be very careful doing it in a bull market.
If you ignore this rule, then play with pennies, play extra small. Ensure that even if the price goes down another 50% you’re going to be just fine!
Play extra defensively, anticipate large dips in a bear market, and adapt your trading strategy accordingly.
If you got lucky and ended up in profit, protect your new position and be quick on the sell trigger. Chances are good that there will be more visits down low.
There are better and safer ways to go about this whole catching-the-bottom thing. Being a hero isn’t one of them. Let’s talk about them in the following articles of the series. Subscribe and follow along.
Disclaimer: Nothing here is financial advice, just a fellow trader meditating on his trading journey, sharing the lessons he learned, and debating some personal opinions that are only that opinions and nothing more.
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