The meaning of “catching a falling knife,” is obvious, but the implications are not. This popular traders’ phrase describes the attempt to make up the losses on an equity you hold that has quickly lost a significant portion of its value by attempting to buy it at or near its low point, then holding on as it rises again, finally making up your losses.
It’s another version of the trading homily: “Don’t fight the tape.” Ticker tapes are long gone, but the admonition lives on. A brief interpretation would be “If the market is falling, don’t assume you can know when to buy back in; if the market is rising, don’t assume you know when to sell to catch the maximum in profits.”
A Historical Example of Knife Catching
The research and news site DailyFX has developed a Speculative Sentiment Index (SSI). The index takes the number of forex traders who have open positions both long and short on various currency pairs and shows the ratio of the positioning on a given currency pair, the idea being that it helps the reader understand changes in investor sentiment by showing dynamic changes in buying and selling patterns.
In one instance, the price of the U.S and Canadian Dollar pair showed a vigorous and rapid increase. As the price continued to rise, the SSI showed that traders were increasingly betting against it and, as it happened, losing their bets. Finally, as the price continued rising traders capitulated and began going with the trend. At that point, the USD/CAD began a long fall. Over the course of the currency pair’s dramatic rise and again over the course of its fall, traders tried to “catch a falling knife,” and in both instances, the knife cut them badly.
Each trader’s losing bet was predicated on the belief that the trader had some valid (and usually “special”) insight into future market performance.
The Psychology Underlying These Axioms
Nobel Prize winning Psychologist Daniel Kahnemann was intrigued by the knife-catching phenomenon and together with Wall Street Journal financial writer Jason Zweig wrote a book about it (and many other related phenomena in the area of judgment and decision-making). The book is called “Thinking, Fast and Slow.” It is a book every trader should read. What Kahnemann and Zweig explore is the thinking behind an investor or trader’s belief that he can catch a falling knife –in other words, predict when the market will turn.
They attribute this to a cluster of fundamental human traits.
First, almost everyone has a tendency to believe they have some special insight that gives them an advantage over others. Second, in critical situations that rapidly unfold (a rapidly falling market we are heavily invested in is a classic example), we tend to rely on our intuitions. It’s a variation of the fight or flight response. When we are losing money fast, we go into fast-thinking mode and prepare to fight. We’d be better off, Kahnemann points out, by slowing down and taking the time to analyze not only the market situation unfolding but our response to it.
What, for example, causes us to believe that we can somehow get back what we’ve lost by a single, drastic trading maneuver? What are the consequences if this attempt fails?
Third, Kahnemann exams over 50 years of investor behavior and concludes that the market is fundamentally unpredictable. Often we don’t notice this. The entire retail finance industry is predicated on our willingness to believe that even if we don’t have the kind of superior thinking needed to outperform the market, we can hire someone to do that for us. As a yearly S&P report points out year after year, most professional investment managers significantly underperform the market. Those that outperform in a given year are overwhelmingly unable to match that performance over time.