Falling Knife

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Definition: Falling Knife

Full Definition of Falling Knife

falling knife is a stock that has dropped dramatically in price over a short period of time.

Falling knives can be quite a trap for investors, the temptation is to buy the stock because it looks cheap now. But stocks don’t always go back up and just because it’s cheap now doesn’t mean the stock can’t get cheaper still. Unfortunately with falling knives, that’s often the case. Many a careless investor has a bought a falling knife of a company that is cheap but still overvalued or a company that has weak business prospects.

If an investor wishes to try to catch a falling knife he or she should keep in mind four things

  1. that the stock should be undervalued not just cheap
  2. a company has the ability to increase its sales and decent business prospects in general
  3. It may be some time before it rebounds, falling knives usually start to fall due to bad news, it can be a while before the news is totally absorbed. You should assume that it will take at least another quarterly earnings (and thus three months) before there is a catalyst for a rebound.
  4. this tactic works best in a bull market

How to Catch a Falling Knife

Buying when a stock is plummeting takes guts, but it can be exceptionally profitable when it works out.

There’s money to be made from catching falling knives. The challenge is doing it without losing a finger.

Accuracy Over Quickness

The first rule of catching falling knives is that accuracy is more important than quickness. Stocks fall because of bad news. That bad news will typically take some time to absorb, so you usually have time to evaluate the investment. And this is one time you shouldn’t rush — it’s important to understand how the news will have an impact on the outlook of the company.

Is it just a one-time event that nobody will remember in a year, or does it affect the business more substantially? Is the company’s competitive position affected? Or, even worse, is its liquidity? You should be looking to catch knives that result in shares being cheap, but don’t substantially affect a company’s long-term outlook.

An ideal knife to catch would have been Merck (NYSE: MRK) below $30 back in October 2005 at the peak of the Vioxx uproar. Merck’s competitive advantage was in its ability to create, acquire, and commercialize drugs, and this advantage was unlikely to be affected by Vioxx. Its balance sheet was solid, with $10 billion in cash. Vioxx was bad, but clearly not a company-killer, and now the stock is above $50.

Wear Gloves

When you’re catching knives, prepare for the worst. Often, a stock will continue falling after you buy it. You should plan for this scenario. One way of doing this is by dividing your money into three piles and buying in thirds. Buy the first third at a good price. If the stock continues to fall, buy the next third. If it drops once more — and the stock seems more attractive than ever — buy the final third.

My rule of thumb is to buy a big enough initial position that I’m content if the stock recovers, but a small enough position that I’m even happier if it goes down and I can buy more at a cheaper price.

Aim For The Handle

The final rule of falling knives is to be certain that the stock is cheap based on your analysis of the company’s potential. Even if a stock has fallen by 70%, that doesn’t make it a good buy. Historical prices have little to do with whether a stock is fairly valued right now. If a company is 300% overvalued, then even if it falls by 50%, it’s still overvalued by 100%. So, before investing, make sure you calculate the company’s fair value based on your current outlook and only buy if the stock is cheap.

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Falling Knife. PayrollHeaven.com. Payroll & Accounting Heaven Ltd. September 28, 2021 https://payrollheaven.com/define/falling-knife/.
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Falling Knife. PayrollHeaven.com. Retrieved September 28, 2021, from PayrollHeaven.com website: https://payrollheaven.com/define/falling-knife/

Definition Sources

Definitions for Falling Knife are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

This glossary post was last updated: 5th August, 2021 | 0 Views.