Falling Knife

What is a Falling Knife?

The best description of a falling knife is a very quick drop in the price of an individual security that may have happened for a variety of reasons.

Investors can end up grabbing the knife’s handle by buying after the slump and enjoying the recovery or the blade and suffering further losses.

Table of Contents Table of Contents

1. What is a Falling Knife?
2. Key Takeaways
3. What Does a Falling Knife Tell You?
4. How to Use a Falling Knife
5. Falling Knife Causes
6. What Types of Stocks are 'Falling Knives'?
7. Falling Knife Example
8. Falling Knife Limitations
9. The Bottom Line
10. FAQs

Show Full Guide

Table of Contents

1. What is a Falling Knife?
2. Key Takeaways
3. What Does a Falling Knife Tell You?
Show Full Guide
4. How to Use a Falling Knife
5. Falling Knife Causes
6. What Types of Stocks are 'Falling Knives'?
7. Falling Knife Example
8. Falling Knife Limitations
9. The Bottom Line
10. FAQs

What Does a Falling Knife Tell You?

As we have discovered, a falling knife is a term that’s used to describe a sudden and substantial drop in a company’s stock price. This rapid fall can provide opportunities for investors to make money through buying at a low point and then enjoying the subsequent recovery.

But the problem is that the stock price may fall further. The inherent dangers and uncertainty involved make it akin to catching a falling knife.

It’s worth noting that the term can describe situations not involving equities. For example, Ed Monk, Associate Director at Fidelity International, recently used it to highlight economic issues.

He said: “Choosing when to cut rates is like trying to catch a falling knife – moving either too early or too late is likely to be painful.”

How to Use a Falling Knife

Investors can use a falling knife scenario as an opportunity to investigate a particular stock to ascertain whether its share price drop is justified. When you try to catch a falling knife it can often go in one of two ways.

The first is that you buy into the stock when it reaches its lowest point. This can be referred to as grabbing the handle as it’s the safest outcome and can provide investors with a decent return.

However, calling the bottom is virtually impossible, even for experienced fund managers with teams of analysts at their disposal.

Therefore, the reality is that the price could continue falling long after you’ve bought into the stock. In this situation, you will have effectively grabbed the blade, not the handle.

You will need to research the stock to draw a conclusion. For example, if you believe the stock price will recover, you may consider buying it.

However, if you expect further falls then it’s probably best to leave it well alone or, if your investment strategy allows, you can consider shorting the position instead.

Falling Knife Causes

It’s important to familiarise yourself with the causes behind a falling knife, as this will have a significant bearing on whether you buy the stock.

For example, is the catalyst a temporary external factor that has caused the market to overreact, or is it a deep-rooted problem within the company itself?

If it’s the former, then there’s more of a chance of everything calming down and the valuation returning to normal. If it’s the latter, then a deeper investigation will be required.

These situations can be caused by:

What Types of Stocks are ‘Falling Knives’?

Of course, the next issue is how to identify a falling knife. The reality is that any stock can become a falling knife.

The interesting point, however, is how to know if one of the falling knife stocks identified has the ability to enjoy a turnaround in fortunes.

For example, a quality company with strong fundamentals is likely to stand a better chance of longer-term success than one that’s financially weaker.

Factors you’ll need to consider:

How about a falling knife vs. a spike? While each refers to a sharp price change, a spike will generally refer to an upward movement.

Falling Knife Example

It’s fair to say that Lululemon Athletica, the producer of athletic apparel, has become an example of a falling knife.

Within just a few days, the company saw its stock price plunge 18% in March 2024 from $476.39 to $388.97 due to its weaker-than-expected outlook.

Unfortunately, prospects are yet to improve. The LULU stock price fell to around $230 by early August 2024, although it was approaching $300 at the back end of October 2024.

Where will its price go next? That’s the question investors will be wrestling with as they decide whether now is an attractive entry point.

Falling Knife Limitations

The problem is that there’s no way of knowing for sure what will happen to a company that has been identified as a falling knife. There are so many variables at play that investors won’t be able to say for certain whether or not the stock price is going to recover.

No one can predict the future, so you’ll need to examine the evidence to gauge whether or not to buy into this opportunity.

You’ll need to:

• Identify what has caused the stock price to slump. For example, is it temporary, or has it been caused by a longer-term problem?
• Examine the company’s fundamentals. Is this a good stock to own? Does it have good barriers to entry, and is it in a strong financial position?
• Do your homework. Research a wide variety of views on the company from sector experts, industry analysts, and commentators.

The Bottom Line

As our falling knife definition has illustrated, this term refers to a scenario in which a stock price falls suddenly and significantly. This can be either a positive or negative for investors, depending on when they bought into the stock. If it was after the slump, they may be able to secure a handsome return on the way up.

However, if the stock price subsequently falls further after they’ve made their purchase, then they could end up losing their investment.

That’s why a falling knife scenario should be used as a sign for investors to fully investigate a company and draw their own conclusions.

FAQs