3. Catching a falling knife

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The catchphrase “Never try to catch a falling knife” means that a stock or index should not be bought while it is falling (going down in value) but one should wait until it bounces off its lows & starts an upward trend (increasing in value) before buying it. It is hard to know when a stock has finished its decline, and they can decline forever it seems or even fall to zero. However it sure feels great to scoop one right off it's all time low and see yourself participate in the entire growth cycle. 

The term falling knife suggests that buying into a market with a lot of downward momentum can be extremely dangerous—just like trying to catch an actual falling knife. In practice, however, there are many different profit points with a falling knife. If timed perfectly, a trader that buys at the bottom of a downtrend can realize a significant profit as the price recovers. Likewise, piling into a short position as the price falls and getting out before a rebound can be profitable. Moreover, even buy and hold investors can use a falling knife as a buy opportunity provided they have a fundamental case for owning the stock.

In the investing world, it is always suggested that “Do not try to catch a falling knife!”, especially if you’re a beginner. Anyways, the investors should proceed with great caution if they are interested to invest in these kinds of stocks. In general, these stocks are extremely dangerous and may result in a severe loss if the investor enters at the wrong time.

How falling knife stocks work?

The journey of falling knife category stocks is pretty straightforward. Initially, the negative news regarding a company can result in the decline of the share price. However, when the situation continues to degrade, it results in a market panic and subsequent fall in the prices. During such cases, there are two possible outcomes:

In a few cases, the share prices may rebound if there is positive news or the company is able to control the damage in the near future. Such scenarios can be extremely profitable for the investors who bought the stock at the discounted price before they bounced back.

However, in most cases, the investors may face severe loss even if they bought the stock at a discounted price if the company’s performance continued to weaken. In the worst-case scenario, if the company goes for bankruptcy, the investors may have to lose most of their investments.

Overall, picking such stocks at the near bottom can result in a massive gain. However, entering these companies at the wrong time may lead to a disaster. There are cases when these stocks never rebounded to the original price for decades since they started falling.

A few recent examples of falling knife stocks in the Indian market

  • Yes Bank: The stocks of Yes Bank have declined over 85% in the time duration between August 2018 to September 2019.
  • Manpasand Beverages: The stocks of Manpasand Beverages has declined over 95% in the time duration between May 2018 to September 2019.
  • DHFL: The stocks of Deewan Housing Finance Corporate Limited has fallen over 90% in the time duration between September 2018 to September 2019.

How to Use a Falling Knife?

As mentioned, there are ways to profit from a falling knife. Many of the trading approaches are time sensitive and require more tools than simply identifying a stock seeing a sharp drop. However, a fundamental case for catching a falling knife can be there depending on the reason for the drop.

There are many different potential causes for a falling knife to occur, including:

  • Earnings Reports: Companies that report their earnings are often subject to volatile swings. If the financial results are lower than expected, the stock may become a falling knife until the market reaches an equilibrium.
  • Economic Reports: Major indexes are often influenced by economic reports, such as employment reports or FOMC meetings. If these reports are negative, stocks can move sharply lower in response.
  • Technical Breakdown: Some falling knives occur due to technical, rather than fundamental, factors. If a security breaks down from key support levels, the price can move sharply lower before finding support below.
  • Fundamental Deterioration: This occurs when the company underlying the stock either badly misses on a key performance indicator like sales, earnings or so on. It also happens when companies are found to be doing something fraudulent or suffering damage in the media.

If the circumstances that led to the falling knife are temporary or do not alter a buy and hold investor's case for investing, then a falling knife could be a buying opportunity. For traders and those with a shorter time frame, it is difficult to time bullish trades correctly.

Reasons for the Company’s Price to fall:

There can be multiple reasons for the company’s share price to decline. Here are a few of the top reasons:

  • A significant decline in revenue and profits for a continued time period.
  • Negative reports and the company continuously missing the market estimates/targets.
  • Deterioration of the company’s fundamentals
  • Discovery of malpractice by the company, fraud charges by SEBI or lawsuits
  • Changes in the management like the resignation of top managers, promoters, etc

Here, if the decline in the price is due to temporary reasons, the long term investor should continue to hold the stock or even buy more. However, if the reason is because of the change in the company’s fundamentals, it’s time to exit, even if you have to book a loss.

Wrapping up

Now that you understand why not to catch a falling knife in the real world and stock market, it’s only logical that we move on to the next big topic - All about averages. To discover the answer, head to the next chapter.

A Quick Recap

  • Falling knife refers to a sharp drop, but there is no specific magnitude or duration to the drop before it constitutes a falling knife.
  • A falling knife is generally used as a caution not to jump into a stock or other asset during a drop.
  • Traders will trade on a sharp drop, but they generally want to be in a short position and will use technical indicators to time their trades.
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