Sharp drops in stocks seen during a week’s time are referred to as a ‘Falling knife”. It is a term used to describe a quick drop in the price of a security, such as a stock. It does not have a specific magnitude or duration to drop before a falling knife constitutes.
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What does it indicate?
A falling knife indicates that buying in a market with a downward trend can be extremely dangerous as it is similar to trying to catch an actual falling knife. If execution is timed perfectly, a trader that buys at the bottom of a downtrend can get a significant profit as the price recovers. Similarly, piling into a short position as the price starts falling and moving out before a rebound can be profitable.
Causes of Falling Knife:
Companies reporting their earnings are subject to volatility swings. If the financial reports are less than expected then there is a falling knife of that stock in the market till the time the market reaches equilibrium.
All the major indexes are mostly influenced by the economic reports such as employment reports or FOMC meetings. The stocks fall lower if these reports are negative.
Falling knives occur if the security breaks down from key support levels, the price falls down before finding another support below.
When the company underlying the stock misses out on key performance indicators like sales, earnings, etc, or is found to be doing something fraudulent or suffering damage in the media, it is said to be a fraudulent deterioration.
- The best example of Falling Knife is Freddie Mac. In July 2008, when people started realizing the housing crisis and its extent, the stock price of Freddie Mac fell down by 77.8% in a month.
- Time and event play a crucial role in profiting from falling knives, thus creating risk.
- There is no guarantee whether the stock will whipsaw or regain momentum, leading to bankruptcy as the only outcome.
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A falling knife is referred to as a rapid drop in the price of a stock leading to a downward trend. Poor earnings, Equity offerings, underwhelming economic reports, and breaking support lines have led to the formation of falling knives. For some investors, a properly timed falling knife leads to profit. Alternatively, if the investor fails to purchase near the bottom of the stock, they incur losses.
Author: Urvi Surti
About the Author:
Urvi is a commerce graduate and has a keen interest in Finance. She has completed her Chartered Wealth Management (CWM) from the American Academy of Financial Management and is currently pursuing a career in Financial Risk Management (FRM).