Put on those welding gloves

Falling Knife
"A slang phrase for a security or industry in which the current price or value has dropped significantly in a short period of time". Investopedia

One of the more difficult stock trades to execute has to be catching a "Falling Knife", otherwise known as knife catching. I have received numerous requests for my philosophy on trading stocks that fit this profile, so I thought I would provide some of my thoughts in a more comprehensive post. Although I believe most traders will avoid this type of trade due to its higher level of difficulty, I believe that a carefully thought out plan can provide one with a tremendous risk/reward scenario.

So, why the comment "put on those welding gloves"? By using this comment, I hope that I am demonstrating that special care is required (and prudent) in trading a falling knife stock. Other components of the strategy required:

1) Patience. Often these stocks that are falling in significant way, may do so for several days. This may actually provide a short-term short trade while you look for a "bottoming" of the stock.
2) Ability to understand clear support lines in a chart, including Fibonacci levels from the recent up or down move.
3) Basic understanding of the FA event that caused the gap down. Even for those that are pure Technical chartist, I advocate a basic understanding of FA in this strategy.
4) Good understanding of price action as the stock finds a bottom (sometimes I refer to this as the "skipping rock on water" phase).

To help wrap all this together, let's study CPB (Campbell Soup Co). At present, This stock is putting in a new base down in the 34.5 price level - this after a gap down from 36.25. CPB has been building this new base for 7 days. I have alerts set for a break above the 34.8 level, and a break below 34 (which would cause me to view this trade as a failure at support).

As always, feel free to send along your comments/suggestions/criticisms. Thanks.

Derald