Catch a Falling Knife…

“How to buy bottoms and sell tops with confidence.”
By Jason Alan Jankovsky, FOREX Analyst & Trader

Almost any trader with some experience has heard the trading maxim (or rule) “Don’t try to catch a falling knife…” It usually refers to buying a market falling in price and alludes to how dangerous it can be to try to get positioned when a market appears to have a lot of potential to continue moving lower. It also has the connotation that the trader himself is part of the problem because of his desire to try and buy a low price; he might “rush” to participate—thereby handing himself a loss. In the case of a market on the move higher traders tend to use the phrase “Don’t stand in front of that freight train…”

In either case—the assumption is that the market is behaving in such a way that it becomes more difficult to go against the prevailing price action in hopes of selling a top or buying a bottom; and that the trader is part of the problem because he can’t wait to make his move. Both metaphors have solid imagery of getting seriously hurt or killed if you were to do such a thing; that is certainly no less painful than losing a large portion of our trading equity in a way that appears to be completely avoidable. It is also important to note that both metaphors imply you have a choice to wait to do something; and you are smart enough to use some common sense. In other words, “What kind of moron stands on a railroad track when a train is coming?” or “What idiot would try to catch a carving knife on the way to the floor? —wait until it gets there.”

In my opinion, this is certainly good advice and full of common sense when applied to a real-life situation (like crossing a railroad track or carving a turkey). But trading is not the real world and the reason most people have frustrating results at best and mounting losses at worst is because they approach the markets in the same way they approach anything else they do— from the SAME real-world paradigm of thought. As I teach in my Psychology of Trading course “Trading is not the real world because it is a zero-sum environment—that doesn’t exist anywhere else in our lives or in society” Without a solid understanding of the psychology of price movement in zero-sum markets it is virtually impossible to get positioned for consistent and significant gains. What is called “common sense” in the real world is exactly the opposite in the markets. In the markets it would be called “following the herd.”

I think it is important that we discuss the fact that EVERY trader out there that is watching a market “crash” is thinking the same thing; namely: “Where will it stop so I can buy? And/or cover my short at the best price?” This is not new and it has always been this way. The vast majority of traders see the same thing in the markets and usually interpret what they see in virtually identical ways. They all do this the same way because they use the same method of thinking that everyone uses in the real world; and they use this thinking in mostly identical ways. That means—as a market “crashes” there will be very few people interested in buying it when it stops declining. They will be interested in buying it AFTER it has shown that a bottom is in place. In other words—they will wait for confirmation before they do anything.

I want you to look at illustration “A” below. Most people would say “don’t try to catch a falling knife” as prices appeared to be REALLY taking the downside seriously. In fact, the price action into the lows was the ENTIRE weekly range from fresh highs to fresh lows in about 10 hours on the clock; not typical price action for any market.

Now look at illustration “B”. This is the same market 72 hours later.

What would have happened if you had indeed “caught the falling knife”? You would have bought at the perfect time for the entire month, taken no heat on the trade, and likely had a substantial open trade gain very quickly.

In my view, the reason most traders will not step up and buy at the actual bottoms or sell at the actual tops—when the risk is the lowest and the profit potential the greatest—is only because they are afraid to be wrong. That is why they wait for confirmation. It reduces their fear of a potential loss. But in reality—it is this fear and need for confirmation that robs them of taking the lowest risk trade at the right time to take it. When the market is already moving in the opposite direction the risk is increasing for a reversal and the profit potential is dropping. This is exactly the opposite of the “common sense” approach that the real world tells you would work—“wait and watch” works wonderfully when you are trying to buy a car or a house—or get a deal on putting in a swimming pool. But “wait and watch” increases your risk and reduces your profits in the markets—so why do most traders do it? Why would you wait for confirmation when it is costing you so much opportunity to do so?

The reason is simple. Most traders will tell you “don’t try to catch a falling knife” because they personally don’t know how to do it. If they did—they would be buying those breaks and selling those rallies ALL THE TIME—because THAT is where the real money is. In fact—no matter how you want to slice it—every trader is trying to buy bottoms and sell tops every day in some fashion—but they don’t call it that. Which is another illusion about the markets that leads to losses. Simply put—no matter where you buy or sell—you are expecting that price to be the LAST time the market was at that price while it moves in your favor—otherwise you would have waited. In effect—you are looking to buy bottoms and sell tops even though you might call it “going with the trend on a pullback” or “going with the breakout” It really doesn’t matter what the method is—you ALWAYS want to be long just before a rally (in effect—long from the bottom) or short just before a drop (in effect—short form the top). There is no way around that thinking and you know it. The problem is—you don’t know how to do it and that is why you suffer losses when you don’t have to—the exact opposite of what you expect from following the “common sense” rule of “don’t try to catch a falling knife”.

So how do we learn to “Catch a falling knife”?

I’m going to show you how I attempt to buy bottoms and sell tops with a high degree of confidence but I want to preface my remarks with a few conditions. First, what I am going to show you is from the sum-total of my 25-plus years of trading experience; some of it will not be an easy thing to grasp at a first look. A lot of it will not make sense to some people or sound overly complicated. None of this is complicated or difficult; it is a learnable skill that requires some effort. Second, there is NO SUCH THING as a 100% reliable way to pick a top or a bottom. Something that can do it more than 60% of the time would be considered an exceptionally beneficial approach. The approach I am going to show you is around 60% successful at finding a LEAD on the market—not necessarily getting to KEEP that lead should a market bounce along that top or bottom for a period of time; or extend a bit further before the actual top/bottom is there. That is more of a money management issue and my rules are different than other traders, so there are times when I let an open-trade gain run back to break-even or a small loss. Last— and probably most important—trading is a thinking man’s game. Conditions change and situations change; that means that every top or bottom is lightly different in quality. It would be foolish for any trader to take what he finds here and run with it exactly as you see it here, all the time. You need to THINK about the bedrock issues first before placing your capital at risk. Again, this is what works for me—think about what the common issues are to your own trading and don’t just try to “plug this in” to your trading today.

I base my analysis on a few assumptions about the market that I have come to understand as factual. First—most people are losing and it is the loser’s liquidation that will drive pricing. A reversal is usually going to happen when the trader going with the trend is “late”; when the loser liquidates he drives prices the other way. For example, if the market has been climbing, at some point the longs coming in will be late; when they sell to liquidate a losing long position the market will reverse lower.

Second, the late trader is ALWAYS waiting for confirmation before doing anything so a top (or bottom) can’t happen until prices have advanced far enough to draw the late trader in. That is a function of TIME and not price. For example—if a market is “crashing” to a buy point the market will make an absolute bottom price and bounce a bit—then go sideways for some amount of time. If enough time goes by, the buyer will come in. After that happens, the price must rise for a long enough period of time for the late buyer to execute his new long position. The early buyer makes the money on the long—the late buyer forms the reversal point.

Third—the sideways price action will be on a lower time frame because the net loser is ALWAYS on a short time frame. When you compare the short time frame consolidation or sideways action it will be at a significant price point on a larger time frame. The large time frame controls the market.

Last—there will need to be a precipitating event to cause the late trader to come in hoping to win; once that event is passed the market will reverse.

Here’s the breakdown on how I went long at the bottom of the market in illustration “A” above:

The market “crashed” to a new 17 month low on high volume and died. The large buy-wick on the candle into the traded lows suggests that the sellers were met with enough buying to stop the decline. THAT IS WHAT SAYS IT IS TIME TO BUY—the fact that the market STOPPED declining on heavy volume. Someone MUST have absorbed those selling orders. I bought right there— 1.2640/60 area with several positions. For the skeptic—I place all my traders on Twitter in real time and you can go back and confirm my tweets showing a BUY in EURO at this precise time/ price relationship. That was on 01-13-2012. My Twitter handle is “theliononline” and you are welcome to subscribe and watch me trade everyday if you wish.

As the market was trading sideways at or near my entry price that was the clue the selling was indeed about over and I was in long at about the right time/price relationship SO FAR. I want you to note that there is NO CERTAIN WAY to know that this particular bottom was “the” bottom—I had to step-up and do the trade WITHOUT anything that most traders would view as “confirmation” In other words, I had to TRUST my instincts that the bottom (which is going to happen sooner or later anyway) was trying to form RIGHT AT THAT POINT.

The market “crashed” into the 17 month lows on the news report that the ratings agency S&P was about to downgrade the credit ratings of several European nations. This would be seen as a bearish development for the EURO. The late sellers were likely afraid to miss the new lows they were certain would occur. Additionally, the COT report (commitment of traders) showed EURO with the third record short position by speculators in as many weeks—more people ALREADY short than ever in history; who was left to sell?

The market was closed over the weekend—which included a federal holiday the following Monday making it a three-day weekend here in the USA. That means the late seller who could trade in Asia Monday created the gap lower seen into the holiday action. Anyone here in the USA waiting for confirmation would have said “that’s it—time to sell!” The market returned to full activity on Tuesday absorbing those sellers until Wednesday and never looked back. The rally was fueled by the late sellers needing to get out from a losing position—there were no traders willing to buy into the 17 month low EXCEPT shorts from above taking gains off the table and the few professional traders who could see that a bottom COULD form. Professional traders who got long at those lows didn’t know the market would ACTUALLY form a bottom until later. The point is—professionals don’t wait for confirmation. They know that it is the loser wanting to wait for confirmation that creates the opportunity. The sideways price action at/around the lows shows that the order-flow was balanced (buyers and sellers about the same size mostly); that means the sellers NO LONGER had the advantage. Something in the market had changed; and that change ALWAYS means a reversal because a market can only do three things—trend up (order-flow imbalance BUYER), trend down (order-flow imbalance SELLER), or trend sideways (order-flow balance— which is ALWAYS temporary).

If you absolutely positively must have some sort of confirmation before trying to buy a bottom or sell a top try and consider that small sideways price action at a significant low or high as what is important.

I’m not trying to give you a two-cent answer to a million-dollar problem. I’m simply saying that if you understand the nature of zero-sum markets, and that the loser is the one who pays the winner, then you would approach price action from a different point of view entirely; namely: “Where is the loser?” not “What will the price do next?” In the case of a sharply falling market that was driven by an unexpected negative news event—once that news event has passed and the market can’t make any additional new traded lows, the probability that the loser is the late short is very high. You buy now—don’t wait for confirmation. As the loser liquidates his losing position—his buy order to liquidate is the bulk of the buying seen as the market rises in price. Prices will rise until all the late sellers are cleared out of the market and the late buyer believes the new trend is now “up”—the late buyers will wait for the uptrend to be confirmed and if there is a precipitating news event that is bullish—they will buy on that news. Now the market is set to reverse lower. Sometimes that structure happens in both directions in just a week or so—sometimes it takes months. But it is ALWAYS this underlying structure that creates a top or bottom so the astute trader must pay attention to what is happening from a slightly different point of view in order to time the buy or sell into the actual market bottom or top.

You will have to really think through this issue but the clues are there. If you are interested in learning more about how to better buy bottoms and sell tops with confidence I would encourage you to attend my daily FOREX briefings and consider attending my quarterly six-week Psychology of Trading course. All the details are on my website