Beware of the Falling Knife

In stock trading, there is a common saying: “Don’t try to catch a falling knife.”

It’s a warning against buying a stock that’s falling sharply and quickly, because even though it might look like a bargain, there’s a chance it could fall a lot more.

Why do even experienced traders sometimes fall into this trap? Amid a broader stock market that’s been subject lately to sudden sell-offs, now’s a good time to examine this phenomenon.

The Allure of “Buy Low, Sell High”

Ultimately, for every stock investor and trader, the goal is to sell something at a higher price than what you paid for it. After all, that’s how you make money. So when a stock falls a lot, the “buy low” lights start to flash in investors’ minds.

The market does tend to overshoot on both the upside and the downside. It’s natural to feel that what’s going down will eventually come up. For market participants, there are few feelings as good as buying a stock at or near the bottom, and then watching it soar.

The problem is that no one knows when or where a stock will bottom. Not even the best traders can consistently predict a bottom. The best you can do is to make educated guesses based on fundamental and technical analysis.

Don’t Be a Hero

As tempting as it is to buy a stock after a 20% fall, there could room to fall further. After all, a stock doesn’t drop 20% for no reason.

Sometimes, you may already hold shares of the stock, and after a big price drop, you want to buy more shares at the lower price to average down your cost basis. While lowering the cost basis makes it easier to break even, throwing more money at a stock that’s falling isn’t always the right play.

There’s also opportunity cost: the money you spent to buy more shares of the stock could have been used to buy another stock that’s doing better.

Thus, often times it makes more sense to wait for the dust to settle than to try to be a hero.

What Goes Down Doesn’t Always Come Up

You should also beware of the dead cat bounce, a temporary and false recovery in a stock. When a stock falls a lot, if it attracts enough bargain hunters (or knife catchers, depending on your point of view) and if enough short sellers take profits, the price will rise. But if there’s no lasting reason to bring in more buyers than sellers, the share price will fall again.

If a stock is trading at a much lower price now than it used to, it doesn’t necessarily mean the stock is a bargain. There’s no guarantee it will ever go back to its previous peak.

Take a look at the chart of Sears (OTC: SHLDQ). The once mighty retail giant is now in bankruptcy and its shares have been delisted from the NASDAQ.

As the chart shows, there have been numerous chances to try to catch that falling knife over the last 10 years. If you timed it correctly, and got out quick enough, you could have made money, but the long-term trend is clearly down. If you timed your purchase wrong, you never made back your money.

For example, if you bought the stock at $60 after it fell sharply from around $90, there’s a good chance you lost money on the investment. Even if over time you bought more shares to average down your cost, it would have been hard to be profitable since the trend was down. It’s better to just avoid a lousy stock.

Do Your Homework

Never assume a stock will inevitably recover its past glory days. Do some homework to see why a stock is down and analyze if it’s worthwhile to bet on a recovery.

If you really like a stock that’s falling, instead of straight out buying the stock, an alternative to consider is to sell an out-of-the-money put option.

Pick a strike price at which you would feel comfortable buying the stock. This would allow you to collect premiums as you wait for the stock to fall more. If the stock is put to you, your cost basis would be lower than if you had bought the stock earlier.

But maybe you’re looking for even bigger gains with less risk. That’s where my colleague Amber Hestla comes in.

Amber is chief investment strategist of the elite trading services Income Trader, Profit Amplifier and Maximum Income. Amber specializes in generating income using options strategies that minimize risk.

Amber is a financial expert but she’s also a military veteran. Amber served with distinction in Operation Iraqi Freedom. While deployed overseas with military intelligence, she learned how to interpret disparate data to predict likely outcomes. Upon her return to civilian life, Amber honed this skill to find money-making opportunities.

Want to learn Amber’s money-making secrets? Click here for a presentation.