The Essence of Knife Catching

“We are what we repeatedly do.  Excellence, therefore, is not an act but a habit.” – Aristotle

The allure of buying a stock that has been crushed in anticipation of a juicy mean reversion is enough to zero out many traders accounts.  On the charts, the positions always look magnificent and take almost no heat.  But the nature of a stock cascading lower is much different than what one finds in a pullback of a prevailing uptrend or even a flat liner.  The stock is falling rapidly in value because there are more sellers than buyers, and the price is exploring lower for interested buyers.  It won’t stop until it’s met with a buying force stronger than the sellers so knowing “where you’re wrong” is vital to preventing portfolio devastation.

Setting a stop is something traders always hammer home, but in my experience the essence of success is more than setting a stop, it’s consistently setting a stop in a methodical manner.  I’ll demonstrate my method with my current knife catch, which is drawing blood from both my palms, MLNX:

The levels I’ve drawn are Fibonacci extensions of the prior swing higher.  The idea is participants who successfully caught the knife the first time will have stops placed below their entries.  Often times the market will go on the hunt for these stops and the next move lower is an artificial lowering of price that will be resolved once the hunt is over.  Of course if price continues lower even more selling could be triggered so get out of the way. 

By defining the setup and repeating the methodology over-and-over, I can build statistics on the trade and based on the win-rate I can determine position sizing.  These types of trades aren’t as high a win rate, but the reward much higher, I usually max out at ½ the size of my normal position.