Saturday, July 11, 2009

Catching Falling Knives

During the past week, the Dow, S&P 500, and Nasdaq Composite each broke down below the neckline of head and shoulders chart formations. Such a break is generally thought to be a fairly strong bearish signal, particularly when combined with weak fundamentals such as in the overall economy including things like high unemployment and low consumer sentiment. While no chart formation or, for that matter anything else, is ever a guarantee of market direction, it can be something that may be helpful if we are aware. I write that because when I make directional trades in a stock, I try to make entries that are consistent with the market and sector direction. The idea, for me, is to try to give myself an edge since obviously when a market is rising most stocks can also be expected to be rising and, naturally, the same is true with respect to sectors. The opposite would also be true in that we could expect most stocks to be down when the market is down. In that circumstance, of course, my bias for directional plays would be bearish.

One of the things I have seen with many traders is that they are so anxious to buy a stock that they make their entry when the price is on the way down. That phenomenon is affectionately known as trying to catch a falling knife. The problem they face is that no one knows how far "down" actually is. For stocks like Bear Stearns or Enron or Lehman Brothers or a host of others "down" wound up being zero. Back in February or March a friend asked me what I thought about buying General Motors and I shook my head from side to side. But it's GM, he said, it won't go under; it has to come back. We have to remember that simply because it was a good company or simply because a company is good now doesn't mean that the stock price will go up. All too often we confuse a good company with a good stock and the two do not necessarily go together. General Electric (GE), for example, has long been a good, even great, company that traded in the $30 and $40 area. This past March it hit under $6 a share. Those who bought at $25, $20, or $15 on the way down were trying to catch that falling knife. I can hear them saying: "It'll come back." Maybe. Probably. But when?

Instead of catching that falling knife, if we like the fundamentals and like the company, why not exercise a little patience and wait until not only it signals a return to an upward move, but also wait until the market and sector head the right way as well? That movement may miss catching the absolute bottom, but it is just fine in my book to take a bite out of the middle once the market, sector and stock suggest that you have a little edge.

I certainly won't argue with those who try to catch those falling knives because at times their timing is near perfect and among the scars on their hands will fall the knife handle just before things turn. However, a very successful and very experienced trader once told me that we only get one perfect high exit and one perfect low entry in our lives and I know I've had mine so, for me, taking a bite out of the middle is just fine.

by Bill Kraft, Editor
Copyright 2009, Makin' Hay, Inc.
All Rights Reserved

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kinfish said...

You said: "For me, taking a bite out of the middle is just fine".
What is the risk that the point you named middle turns out to be top or bottom?

Anonymous said...

I think I can answer Kinfish's question: Go with the trend!!

I recall hearing about a successful trader who described himself as a "Pineapple Trader". He didn't look to buy at the bottom or to sell at the top, but to get into each trade in its juicy part.

The first "rule" for being a good Pineapple trader? Be sure you're going with the trend.

In addition, keep in mind that patience frequently mints money. patient; go with the trend; THEN you improve your chances of getting to the "juice".

~ Gemma Star

kinfish said...

Gemma Star, how do you know that trend have not reached its turning point?

Bill Kraft, said...

Kinfish, thank you for writing. Obviously, we can never be certain what tomorrow may bring. The entry could turn out to be a top or bottom, but, as Gemma Star notes, if we enter near a trend line, the break of that trend can provide a disciplined exit. In other words if the trend is quickly broken we have cut our loss; if the trend continues we are letting our profits run.
Bill Kraft

Anonymous said...

If I could offer a better answer than Bill Kraft did, I would.


Anonymous said...

Indeed, that is what Jim Cramer teaches -- buying on weakness/selling into strength, over and over again around a core position. As he doesn't believe in using stop loss orders his viewers assume that the more a "great company" falls the more they should buy. He is one Smart Guy, no?

Anonymous said...

Excellent advise but the very first stock that you feature as a good long candidate is GE despite the fact that it chart clearly illustrates that it is a poster child example of a falling knife.

Eclectic Recluse said...

I have found that catching falling knives is one of the most profitable of the 40 systems I trade. BUT they are 'risky' (i.e. can show significant losses), So the system has to be played appropriately. For me this means:

- take a few small positions (they're unpredictable so a bit of diversification helps)
- make sure falling knives only constitute a small part of your portfolio (5% max for me -- I'm risk averse)
- don't buy options, write if you must (the volatility will fall when the underlying bounces)
- only hold them for the first short bounce (that's where the value lies)
- never lose your nerve i.e. no stop losses (it's extremely rare for a knife not to bounce, and even if you make an overall loss, when the bounce comes it reduces the loss)
- the best time to catch falling knives is when the market is also falling sharply (because when it bounces, so will most falling knives). -- but I buy them steadily and consistently in all market conditions

good luck

Unknown said...

I keep buying GE on the way down for long-term. This is a great company. I also have been buying Elan which is dropping every day after JNJ gave them one billion $. Yes, they were in debt until now. They will post earnings on July 21.

Bill Kraft, said...

I don't know how smart Jim Cramer may be, but I do know that continuing to buy falling shares of great companies like Enron or Lehman Brothers or GM (pre-bankruptcy) sometimes doesn't work out too well.
Bill Kraft

Bill Kraft, said...

Thanks, Anonymous. I certainly did not feature GE as a long candidate though it may well become one if it can return to a trend up. I used it as an example of a falling knife issue on the past behavior.
Bill Kraft

Bill Kraft, said...

Thanks for the comments, Eclectic Recluse. While catching falling knives is not something I try to do myself, I can understand how you have met with success using your plan. Most impressive is that you do have a plan and one that has worked well for you. Congratulations!
Bill Kraft

Bill Kraft, said...

No question that GE is a great company, Pepper. The issue is whether it has been a great stock. It fell from over $42 a share in the last quarter of 2007 to under $11 at Friday's close. We need to keep in mind that if a stock price drops 50% it needs to move up 100% just to get back to break even. GE needs a move of over 380% to return to the 2007 high. Of course it may achieve that, but my point is that those who were buying at $40, or $30, or $20 probably wished that they had waited until it turned back up and entered with the direction of the move. Elan was over $37 a share the middle of last year and then tanked to the current level of $6.78. While that isn't good for anyone owning the stock or buying it on its precipitous drop, it definitely does not mean it can't move back up. The keys for me are when to enter and when to exit. My question to you is when is the long term? If you are a buy and hold investor, until when do you hold? Would you have advised investors to buy and hold Enron or Lehman Brothers or GM? The same logic would have applied to those once great companies.
Bill Kraft

Unknown said...


You never cease to amaze me. What a perfectly written letter! Good going, you have my vote. Very wise trading advise, which is quite rare.

Robin Martin

Bill Kraft, said...

Thank you, Robin. I sincerely appreciate your comment.
Bill Kraft