Definition
“Catching a falling knife” in investing is a term used when a trader buys a stock after a significant decline in its price, hoping that the price will rise again, but the stock price continues to fall. This leaves traders bearing losses.
How does “Catching a Falling Knife” work in investing?
When traders try to time the market and buy stocks that are declining, hoping that the stocks will bounce back and increase in value, they often find themselves catching falling knives. When the stock prices continue to drop, these traders find themselves incurring losses.
Think of it this way: if you’re working in your kitchen and the knife slips off the counter with the sharp end pointing downward, you’re likely to cut your hand if you try to catch it.
Stock prices are affected by a number of factors. Falling knives are stocks sold for more than what fundamentals support due to recent news or a poor earnings report.
What happens when a stock price starts to decline?
Usually, bad news prompts some shareholders to sell their stocks, leading to lower prices. When the price starts to decline, this may trigger additional selling from other investors, fearing more losses.
Note: Many investors and traders use stop-loss orders, which are types of transactions that lead to selling stocks when a certain price level is reached.
If the stocks are declining, sales may occur as a result of such orders, which are executed automatically.
There may also be short sellers profiting from falling stock prices. Short sellers enter a contract to sell stocks they do not own (typically borrowed stocks). As the stock price drops, they acquire the stocks at a lower price and deliver them to the person they agreed to sell them to at a higher price while keeping the difference.
The number of sellers easily surpasses the number of buyers, and the stock value drops faster than anyone expects.
Investment Strategies for Low Stock Prices
There are strategies for investing in stocks that are experiencing continuous declines in their prices: contrarian value investing and swing trading. Contrarian value investing is when investors look to hold the stock for the long term and benefit from short-term weakness.
Traders who are engaged in swing trading aim to make a quick profit if the stocks bounce back the next day or within days or months. The key in both strategies is to ensure you’re not actually catching a falling knife. Instead, you should be catching a ball that bounces back quickly.
Note: Even expert traders have no way to time the market with complete success. Individual investors are advised not to make investment decisions based on market timing.
Example of “Catching a Falling Knife” in Investing
A recent example of a falling knife stock is Netflix (NFLX). On April 19, 2022, Netflix released an earnings report showing that the total number of subscribers had decreased, predicting more subscriber churn in the future. The stock price dropped to $348.61 on April 19 and opened at $245.20 on April 20. This was a 30% drop in one day.
Investors and traders who tried to catch the falling knife continued to see ongoing losses as the stock price fell below $200 per share in July 2022. By September 2022, the price had not exceeded the $300 per share threshold.
What Does This Mean for Individual Investors?
The key for individual investors is not to time the market. If the market turns out to be right about the stock, catching a falling knife will lead to significant losses as the stock price continues to decline. However, if the falling knife turns out to be a bouncing ball, this could lead to substantial gains.
Questions
Frequently Asked Questions (FAQs)
How does the market cause investors to catch a falling knife?
The market causes investors to catch a falling knife when it overreacts to short-term news. If stocks plummet due to trivial news unrelated to the company’s fundamentals, investors may be tempted to buy in hopes that the price will recover. However, if selling pressure continues and the price does not recover, investors may find themselves incurring losses.
How can investors avoid catching a falling knife in stocks?
Individual investors should avoid trying to time the market or making investment decisions based on stock price movements. If you hold stock for the long term, you are more likely to recover from any short-term losses you incur. According to Charles Schwab research, since the 1960s, bull markets (where stock markets rise more than 20%) have lasted an average of six years, delivering an average cumulative return of 200%. Conversely, bear markets (a drop of 20%) only lasted an average of 15 months during the same period, with a slightly negative cumulative return of just over 38%.
Was this information helpful?
Thank you for your feedback! Please let us know why.
Sources:
– European Central Bank. “Working Paper Series – Catching Falling Knives and Predicting Market Reactions”. Page 3.
– Gabelli School of Business at Fordham University. “Value Investing”.
– Netflix. “Netflix Financial Results for Q1 2022”.
– Yahoo Finance. “Netflix, Inc. (NFLX) – Historical Data”.
– Charles Schwab. “Stock Market Volatility: Inflation Strikes Again”.
Source: https://www.thebalancemoney.com/what-does-catching-a-falling-knife-mean-1344945
.lwrp .lwrp-list-item:not(.lwrp-no-posts-message-item){
}
.lwrp .lwrp-list-item img{
max-width: 100%;
height: auto;
object-fit: cover;
aspect-ratio: 1 / 1;
}
.lwrp .lwrp-list-item.lwrp-empty-list-item{
background: initial !important;
}
.lwrp .lwrp-list-item .lwrp-list-link .lwrp-list-link-title-text,
.lwrp .lwrp-list-item .lwrp-list-no-posts-message{
}@media screen and (max-width: 480px) {
.lwrp.link-whisper-related-posts{
}
.lwrp .lwrp-title{
}.lwrp .lwrp-description{
}
.lwrp .lwrp-list-multi-container{
flex-direction: column;
}
.lwrp .lwrp-list-multi-container ul.lwrp-list{
margin-top: 0px;
margin-bottom: 0px;
padding-top: 0px;
padding-bottom: 0px;
}
.lwrp .lwrp-list-double,
.lwrp .lwrp-list-triple{
width: 100%;
}
.lwrp .lwrp-list-row-container{
justify-content: initial;
flex-direction: column;
}
.lwrp .lwrp-list-row-container .lwrp-list-item{
width: 100%;
}
.lwrp .lwrp-list-item:not(.lwrp-no-posts-message-item){
}
.lwrp .lwrp-list-item .lwrp-list-link .lwrp-list-link-title-text,
.lwrp .lwrp-list-item .lwrp-list-no-posts-message{
};
}
Leave a Reply