A falling knife is a metaphor used in the investment world to describe a stock that has lost value and is currently plummeting. The term comes from the dangerous scenario of catching a knife as it falls, which can easily result in injury.
However, with the right techniques, investors can catch falling knives and avoid potential mistakes.
In this article, we will discuss what is a falling knife, how to catch it, and some tips for avoiding losses.
Falling knife meaning
The term falling knife is used to describe a stock that has lost value and is currently in free fall.
While the exact definition can vary, it generally refers to a stock that has dropped more than 20% from its 52-week high. Falling knife stocks can sometimes become value traps, and one of the most common mistakes investors do is to try to catch too many falling knives.
Falling knife example
For example, let’s say Company XYZ was trading at $100 per share last year. Over the past year, the stock has fallen to $80 per share, representing a 20% drop. In this case, Company XYZ would be considered a falling knife.
What does a falling knife has no handle mean?
The phrase “a falling knife has no handle” is often used in the investment world to describe a stock that is in free fall and may be too risky to catch.
This phrase originated from the dangerous scenario of catching a knife as it falls, which can easily result in injury.
The same risks apply to catching falling knives in the stock market – if you’re not careful, you could end up losing a lot of money.
What is the proper technique to catch a falling knife?
There is no one-size-fits-all to catch a falling knife, as it will vary depending on the situation. However, here are three tips for catching falling knives.
These are the most popular techniques that investors use to safely catch falling knives and avoid losses:
Stabilize before buying
One technique for catching falling knives is to wait for the stock to stabilize before buying shares.
This means that you would wait for the stock to stop falling and start trading in a narrow range before buying. It's important for the price to stabilize because it indicates that the selling pressure has subsided and the stock is no longer in free fall.
This technique requires patience, but it can help you avoid buying shares at the bottom of the decline.
It is also common for some investors to wait for a stock rebound. Once the stock reaches a certain low they will monitor the price and include the stock in their watchlist.
They might wait until the stock rises by 5% to 10% from the lows to determine that the selling pressure ended.
Another approach is to buy shares of the stock gradually over time. This allows you to average into your position and reduce your risk.
It can be tempting to try to catch the bottom by buying all at once, but this is often a mistake. It’s better to buy shares gradually over time so that you don’t get burned if the stock continues to fall.
This is a common investment approach that is in many ways similar to dollar-cost averaging (DCA). You may approach a falling knife with this strategy, but you need to be careful when defining your DCA frequency.
The reason is that stocks can decline for years, and if you start buying daily, you might run out of funds fast, and end up with a losing stock in your portfolio.
Use stop-loss orders
Stop-loss orders are another tool that can be used to catch falling knives. A stop-loss order is an order to sell a security when it reaches a certain price.
This can help limit your losses if the stock continues to fall. This trading tool can be helpful, but it’s important to use it carefully. If the stock price gaps down, you may end up selling your shares at a much lower price than you intended.
Each of these techniques can help investors avoid losses and maximize profits when catching falling knives.
How do you catch falling knife stocks?
First, you need to identify which stocks are following the trading pattern of a falling knife. To identify these stocks, you will need to look for a few key indicators:
- A stock that has been declining rapidly in price over a short period of time
- A high volume of trading activity during the price decline
- A stock that is trading below its moving averages
Once you have identified a stock that is following the falling knife pattern, you need to wait for it to reach the bottom before you start buying.
You can identify the bottom of the falling knife pattern by looking for a few key indicators:
- A stock that has reached a new 52-week low
- A sharp increase in volume
- A stock that is starting to rebound off its lows
Once you have identified these indicators, you can start buying the stock. However, you should only buy a small position at first. If the stock continues to fall, you can add to your position.
A falling knife is a term used to describe a stock that is declining rapidly in price. Following the falling knife pattern can be a great way to make money in the stock market. However, you must be patient and wait for the stock to hit bottom before purchasing.
Catching a falling knife is a risky proposition, but if done correctly, it can be a lucrative one. By understanding what a falling knife is and how to catch it, investors can better protect themselves and their portfolios.
If you follow these simple rules, you can make a lot of money catching falling knives in the stock market.