A falling knife is a stock that has dropped dramatically in price over a short period of time.
Falling knives can be quite a trap for investors, the temptation is to buy the stock because it looks cheap now. But stocks don't always go back up and just because it's cheap now doesn't mean the stock can't get cheaper still. Unfortunately with falling knives that's often the case. Many a careless investor has a bought a falling knife of a company that is cheap but still overvalued or a company that has weak business prospects.
If an investor wishes to try to catch a falling knife he or she should keep in mind four things
- 1) that the stock should be undervalued not just cheap
- 2) a company has the ability to increase its sales and decent business prospects in general
- 3) It may be some time before it rebounds, falling knives usually start to fall due to bad news, it can be a while before the news is totally absorbed. You should assume that it will take at least another quarterly earnings (and thus three months) before there is a catalyst for a rebound.
- 4) this tactic works best in a bull market