FX Strategy "Falling Knives"

The markets have a way of giving us surprise moves. That’s what they are known for. When something unusual or unanticipated happens, especially if it goes against what the public is expecting, price moves strongly. That’s when markets become volatile and can create havoc on your trading results. This type of price movement is usually referred to as a “falling knife” and sometimes it can create trading opportunities, especially in the currency markets. But these types of moves can also be risky, so when you catch falling knives (as the saying goes), there are some factors you need to consider.

For starters, proper timing is important because, face it, when markets are falling, it is not unusual for traders to think a bottom has been reached. So what often happens is traders end up opening long positions and sometimes find that prices drop even further. How can you avoid getting into such a situation? After an unusual bear currency market, it makes sense to open a long trade. It’s almost like you’re getting a deal. But the markets could continue lower, which is why you need to add an effective technical filter to help identify whether a shift in trend is indeed happening. You need to make sure price has already turned up and is trending upward. I use the 20-period exponential moving average (EMA) on a four-hour chart to help me time my “falling knife” trades.

If price is above the EMA 20 on the four-hour chart, it indicates that price is moving up. It’s a good idea to look for the falling knife on a daily chart first before drilling down to the four-hour chart. This simple idea has helped me avoid many losing trades and take more winning trades. Here’s how I apply the strategy. A falling knife must have a minimum 1,000-pip drop within a few days, or preferably within 24 hours. Following a falling knife action, on a four-hour chart, I go long when price crosses the EMA 20 to the upside, closes above it, and forms a subsequent bullish candle.

Trade details:
Stop: 250 Pips
Target: 500 Pips
Risk/Reward Ratio: 1:2
Volume of trade: Use 0.01 lots for each $2,000 (that is, 0.05 lots for $10,000); or 0.1 lots for each 20,000 cents in a cent account (0.5 lots for each 100,000 cents).
Maximum duration of trade: One month for each position
Exit: A position is left open until the stop or the breakeven stop or the target is hit; or until a period of one month has elapsed.

Examples of Falling Knives

Figure 1

During the bear market of 2008, the Australian dollar/US dollar (AUD/USD) pair dropped more than 3,810 pips from a high of 0.9849 to a low of 0.6008. This was followed by a recovery of 3,300 pips the following year (Figure 1). A move like this could create opportunities for those who knew how to time good bullish signals.

Figure2

In 2011 the earthquakes in Japan sent ripples across all financial markets. Forex markets were also hit, and this was evident especially on JPY pairs. In Figure 2, you see that the Canadian dollar/Japanese yen (CAD/JPY) declined by 8,300 pips, after which the market rallied by 12,400 pips.

Figure3

In Figure 3 you see how the effect of the January 15, 2015 decision by the Swiss National Bank (SNB) to allow its currency to trade freely against the euro on CHF pairs.

On June 24, 2016, after the Brexit referendum, the British pound (GBP) pairs fell like lead weights. From the four-hour chart of the GBP/USD in Figure 4, it looks like the bulls were making attempts to create a rally in those markets. Even though their efforts may not have worked in their favor, the GBP/USD is likely to trend upward soon from that point. If you were following my catching falling knives strategy, you would buy GBP/USD when it crossed above the EMA 20 (red line) and is followed by another bullish candle. After entering your long position, you would set a target of 500 pips and a stop of 250 pips.

Figure4

Source: Stocks and Commodities Magazine

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