What Is ‘Catching a Falling Knife’ in Investing?

‘Catching a Falling Knife’ in Investing Explained in Less Than 5 Minutes

Definition

Catching a falling knife” in investing is an expression for when a trader buys a stock after a big drop in its share price, hoping the price will rebound, but the stock price continues to fall. That leaves the traders incurring losses.

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Key Takeaways

  • “Catching a falling knife” is when a trader buys a stock that recently had a big stock price decrease.
  • Value investors try to catch falling knives and hold them for the long term, while scalpers buy to quickly earn a profit, then sell.
  • Traders should beware of catching a falling knife and averaging down if the situation has really changed.

How Does ‘Catching a Falling Knife’ Work in Investing?

Traders looking to time the market and buy stocks that are falling, hoping the stocks will rebound and gain in value, are often left catching falling knives. When stock prices continue to fall, that leaves those traders staring at losses.

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.

Note

Many investors and traders use stop losses, a kind of trade that triggers a sale of shares when a particular price threshold is reached.

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.

Note

Not even expert traders have a way to time the market with complete success. It is recommended that individual investors not make investing decisions based on market timing.

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.

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 a stock collapses due to news that isn’t material to the economics of the business, investors may be tempted to buy the stock, hoping the price will recover. However, if the selling pressure continues and price does not rebound, investors can be left staring at losses.

How do you avoid catching a falling knife in stocks?

Individual investors should avoid trying to time the markets or make investing decisions solely on price movements in stocks. If you hold stocks over the long term, you’ll likely make up for any short-term losses you incur. According to research by Charles Schwab, since the 1960s, an average bull market (where stock markets are up more than 20%) lasted six years, delivering an average cumulative 200% return. Bear markets (a drop of 20%) over the same period lasted only 15 months on average, with a cumulative negative return of a little over 38%.

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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. European Central Bank. “Working Paper Series - Catching Falling Knives Speculating on Market Overreaction.” Page 3.

  2. Fordham University Gabelli School of Business. “Value Investing.”

  3. Netflix. “Netflix Releases First-Quarter 2022 Financial Results.”

  4. Yahoo Finance. “Netflix, Inc. (NFLX) - Historical Data.”

  5. Charles Schwab. “Stock Market Volatility: Inflation Strikes Again.”

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