Many experienced investors forgot a popular stock market adage to “NEVER CATCH A FALLING KNIFE” when they picked Apple stock (AAPL) at $500 a share. This seemed like a very attractive price as the stock had already fallen 30% over the prior three months. What is a young investor to learn about how to pick the right stock from Apple dropping an additional 10% today?
What is a “falling knife?”
A security is considered a “falling knife” when it’s price has been trending down for a period of time. These securities may rebound, but most savvy investors stay away as it is impossible for novice investors to pick the stock’s bottom. As the phrase suggests, buying into a market or a stock with a lot of downward momentum is quite dangerous. If you are one of the lucky few that time their purchase perfectly, a buy at the bottom of a long downtrend can be quite rewarding – but the risks outweigh the rewards.
As an investor analyzes a stock like Apple, which recently lost a significant portion of its worth, they may feel an overwhelming temptation to invest. The reasoning may be that “If it was worth $700 just three months ago, then isn’t it a better value at $500 today?” The reason it may not be a better value today is that institutions with big money who buy big blocks of stock may have the inside scoop. They get more access to insider type information and know better than the common investor about the financial condition of a company. They also get economic and market intelligence that few are privy to. You must realize that it is this big money that moves stock prices, not the little investors buying 50 to 100 shares at a time.
When the news finally drops about the internal issues for Apple, as it did on its January 23rd 2013 quarterly earnings release, many investors run for the doors (sells their holdings) which adds to the stock’s supply and forces more erosion of the stock’s price. At this new lower price, the institutions may or may not determine that the stock has reached a value that their intelligence has specified is a new buying opportunity for the stock. So, it is best to sit back and wait for the real bottom to form and watch for the next uptrend.
The lesson for all buyers is that unless you have the real inside information, do not buck a stock’s trending price and never buy a stock that is falling. Catching a falling knife is an adage that we all too often forget. It is a confirmation of the other adage that “the trend is your friend.”
Reverse Head and Shoulders
