WHAT DOES IT MEAN TO CATCH A FALLING KNIFE?

By: Sean Ryan

When investors speak about “catching a falling knife,” they aren’t talking about actually attempting to grab a meat cleaver as it plummets to the ground, but about a type of trade that can be equally hazardous to your (financial) health.

What the phrase actually refers to is the temptation to jump in and buy a stock that is in free-fall following bad news.

These situations are often referred to as “value traps.” The stocks look cheap relative to where they once traded, but are not irrationally cheap – they are cheap for a reason. That reason – whatever the news was that sparked the sharp decline – may be a new permanent feature of the landscape, so that the stock that looks cheap will remain so for a long time, and perhaps grow cheaper still.

After bad news, the price at which a stock seemed attractive before the news came out may no longer be so attractive. It is critical to fully think through the implications of the news driving a stock down, and avoid basing trading decisions on your understanding of a company’s prospects prior to the bad news.

Another factor is that in times of uncertainty, markets frequently overreact; they can be irrational. And once the market gets a little irrational, there’s no reason it can’t get a lot irrational.

Recall the internet bubble – stocks that seemed outrageously overvalued at $200 per share sometimes went on to reach $400 per share or higher before falling back to Earth. An investor who shorted such a stock at $200 would have been intellectually correct, but would also have suffered horrifying losses before the market ultimately vindicated them.

As those internet stocks peaked and then collapsed, they provided a perfect example of the danger of attempting to “catch a falling knife” – they illustrated the fact that sometimes when stocks fall, they simply never bounce back.

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