Think of it like this: If you’re working in your kitchen and the knife slides off the counter with the sharp end pointing down, you’re likely to cut your hand if you try to catch it. Stock prices are impacted by a number of factors. Falling knives are oversold stocks that are falling more than the fundamentals would support because of a recent news item or bad earnings report.
What Happens When a Stock’s Price Starts Falling
Typically, the bad news causes some stockholders to sell shares, which drives prices down. When the price begins to fall, it might lead other investors to sell, fearing further losses. If the stock is falling, there may be sales that occur as a result of such trades being automatically placed. There may also be short sellers who benefit from falling prices of a stock. Short sellers enter into an agreement to sell shares they don’t own (typically borrowed shares). As the stock price falls, they acquire the stock at a lower price and deliver it to the person they agreed to sell it to for a higher price while pocketing the difference. The number of sellers easily eclipses the number of buyers, and the stock quickly falls far more than anyone would have anticipated.
Investing Strategies for Falling Stock Prices
There are strategies to invest in stocks that are witnessing a continued drop in their stock prices: contrarian value and scalp trading. Contrarian value investing is where investors look to hold the stock for the long term and are taking advantage of short-term weakness. Swing traders, typically, want to scalp the stock and make a quick profit if it bounces back over the next day, week, or months. The key in both strategies is to make sure you’re not actually catching a falling knife. Instead, you catch a bouncing ball that goes right back up.
Contrarian Value Investing
Value investing is a type of fundamental investing where investors calculate the intrinsic value of a stock and only buy when it trades for a substantially lower number. Over time, the stock should revert to its intrinsic valuation, and value investors will profit. Contrarian value investors buy stocks when those stocks are most hated by the market, including falling knives. Investors look for opportunities where news has driven the stock price down, but the fundamentals of the business are still strong. Value investors can add value to their portfolios by “skillfully catching falling knives,” said Joe Koster, managing member and investment adviser for Sorfis Investments, a value- focused wealth management firm, putting extra emphasis on the word “skillfully.” “If you’re wrong about valuation, then catching falling knives can lead to bigger and bigger losses, ’’ said Koster. But if you’re right, then by averaging down, you can “both increase your returns (and) at the same time, you’re actually reducing your risk by buying that good value at a cheaper and cheaper price,” Koster said.
Scalp Trading
Scalp trading is a short-term version of value investing. “Scalping” is the term for quickly moving in and out of stocks that have been overbought or oversold. “Scalping” is a commonly used term in day trading, but the concept can also be applied to swing trading over a few weeks or months. When scalpers catch a falling knife, they have the same general thesis as value investors—that the herd-like behavior of the market drove the stock price down farther than it should have gone—but the difference is the time frame. Scalpers want to make a quick profit, then get out.
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 that showed total subscribers had fallen, and forecasted more future subscriber churn. The stock price closed at $348.61 on the 19th and opened at $245.20 on the 20th. That’s a drop of 30% in one day. Investors and traders who attempted to catch the falling knife continued to see losses as the stock fell below $200/share in July 2022. As of Sept. 2022, it had yet to cross the $300/share threshold.
What It Means for Individual Investors
The key for individual investors is not to time the market. If it turns out the market is right about the stock, catching a falling knife will lead to big losses as the stock continues to fall. That said, catching a falling knife that turns out to be a bouncing ball will lead to great returns.
