Falling Knives

A Technical Analyst and a Fundamental Analyst are chatting about the markets in the kitchen. Accidentally, one of them bumps a kitchen knife off the counter, landing right in the Fundamental Analyst’s foot! The Fundamental Analyst screams in pain at the Technician, asking him why he didn’t catch the knife. “You know Technicians don’t catch falling knives!,” the Technician responded. He then asks the Fundamental Analyst why he didn’t move his foot out of the way? The Fundamental Analyst responds, “I didn’t think it could go that low.”

By now, we’ve all read about, watched, or heard about the most recent market action. Or if you’re like me, you see it in the charts as you game plan future trades and exits. As the joke above illustrates, the power of technical analysis is that it helps us identify when to be in or out of any liquid, chartable security. Our whole goal is identifying low risk / high reward trades. We don’t care about being right. We only care about making money in the market so we appreciate knowing when we’re wrong.

08-24-2015 SPX Falling Knife

For example, when we look at the price action of the S&P 500 on the chart above, we can see that the U.S. equity market had been moving sideways for quite a while. And recently, it broke its lowest upward trend line. Once this trend line broke, there was too much risk inherent in this index. In fact, I would argue that this was a great low risk / high reward scenario to short the S&P 500 using an instrument such as SH or SPXU.

We have an intermediate time bias when we look for opportunities – our time horizon is weeks to months. Our approach does not necessarily match the approach of day traders or long term investors. However, one would think it is beneficial for all investors to know when a 10% loss outweighs the probability of any short term gains. As a reminder, it takes a 11.1% gain to recoup a 10% loss. We think it makes sense for all investors to avoid a 10% loss, even if your time horizon is 10 years.

Trade safe.

Disclosure: The author is long SH.

Disclaimer: Nothing in this article should be construed as investment advice or a solicitation to buy or sell a security. Simply put, you are an adult. You invest based on your own decisions.