Catching a Falling Knife


Wall Street has a lot of sayings developed by traders who learned one lesson or another, usually after losing a great deal of money.  One of the bromides is to “catch a falling knife,” usually used in phrases like “He tried to catch a falling knife with that stock and lost his shirt.”

In stock market parlance, to “catch a falling knife” if to buy a stock that is declining rapidly in price with the hopes of buying the stock at the bottom, thereby getting a good price, from which the stock rebounds sharply, leading to a quick profit.  As would be the case with trying to catch a real falling knife (picture point side down, razor-sharp, rocketing towards your foot) the maneuver is tricky.  If you move too soon, you will be rewarded with a slice in your finger or a point in your palm.  If you move to slowly as the handle whizzes by, you’ll miss the knife entirely.

Buying falling stocks is a form of value investing, in which an investor buys stocks that he believes are undervalued and holds them until he believes they are fairly valued or overvalued.  The general premise is that an undervalued stock will eventually return to its fair value, and that undervalued stocks will do better than overvalued stocks.  Value investing is based on the “buy low, sell high” philosophy.  This strategy has proven itself at various points in the past, although in recent years the momentum investing approach (buy high, sell higher) has actually been more profitable.

 

        

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The trouble with buying declining stocks is that stocks that are falling rapidly in price are usually falling for a reason.  Looking at the current British Petroleum fall, the stock is declining because the clean-up efforts from the oil spill will cost unknown billions of dollars, which in turn will hurt earnings.  There is speculation over whether the dividend will be cut or eliminated, how big the losses will be, and how much will be paid in legal costs and claims resulting from the numerous lawsuits that will no doubt come in the next year or two.  In addition, the actions that the US Government may take and their effect of future profitability are unknown at this point.  Because stock investors hate uncertainty the price will continue to fall. (Even if the news is bad, if you know the numbers you can value a stock.  If there is uncertainty no one knows how to value the stock and therefore are afraid to step in and buy).

The only time to try to catch a falling knife is when the whole market is declining, and then to pick up shares of a stock you have determined to be a good long-term buy and were accumulating anyway.  In this type of situation, good stocks and bad tend to decline, so your great company will fall along with everything else.  When the markets turn around, the great stocks are the first to shoot back up, providing once-in-a-lifetime returns.

To determine if the whole market is declining, rather than just your stock, look at the mid-term charts (maybe 6-month time span) of several stocks.  If they all look about the same, with head and shoulder patterns and then a downward trend, the whole market is falling (the current market is like this).  If only the stock you are interested in is falling, it is best to stay away because there is probably something other know that you don’t (yet).

 

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If you determine that the whole market is falling, the way to catch the knife is to wait for the initial decline to start to slow and flatten out and then buy about 1/3 of the number of shares you will eventually buy.  Then, wait for the rise and hope it is a bear-market, “suckers” rally.  If it is, wait for the stock to decline beyond the previous low and then wait until it begins to flatten again.  Buy the second 1/3 here.  Repeat one more time if the market cooperates and there is a third downturn.  If the stock moves up and crosses the original high (the “head” of the “head and shoulders” pattern) wait for the subsequent low and buy the rest  of the shares because the fall is probably over.

After you are all in, just sit back and wait.  The stock may fall farther, but by buying in stages you lower your cost basis and also are aided psychologically.  As the stock moved to new lows, since you were hoping it would continue to decline, you don’t get the self-doubt that you get when you buy the full position at once and see the price continue to decline.  It is almost impossible to catch the exact bottom, but this way you had three tries.  Eventually the stock should recover and set a new all-time high if you picked the right kind of stock, so whether you got the exact bottom or not won’t really matter.

Happy catching!

Join the conversation and help make this blog more exciting!  Please leave a comment.  Also, if you have an investing question, email  vtsioriginal@yahoo.com or leave the question in a comment.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

What is a Short Sale?


The term “short sale” has come more into the popular vernacular lately in reference to the real estate transaction in which the lender allows the borrower to sell a house for less than is owed for the property.  In stocks and other securities a short sale is something entirely different.  Today I will discuss short sales as they relate to securities.

In securities, a short sale goes as follows – An investor (or speculator) calls her broker and says that she wants to sell 100 shares of company XYZ short at $50 per share.  Her broker goes out and borrows the shares (usually from someone who has a margin account who is currently on margin) and then sells the shares for $50.  The broker deposits the proceeds, less commissions, in the investor’s account.  At some later date, to close the transaction, the investor must purchase the shares, replacing those that were borrowed.  (Note that this person will probably not know that the shares were every borrowed, and if he decides to sell his shares during the period shares from another person must be found and used for the sale.)  If the company pays a dividend while the short seller still has the position open she must pay the dividend to the person from whom the shares were borrowed (who again doesn’t know they are gone).

 

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If the investor who did the short sale is able to buy the shares back at a lower price, say $40 per share, she will make the difference in price ($50-$40)x100 = $1000, minus commissions and any dividends she had to pay.  If the stock rises above the price she sold them for and she closes the position, she will lose money.  Obviously, stocks are sold short when an investor thinks it will decline in price.  Because stocks naturally tend to increase in price (because of inflation if nothing else), selling short is not a long-term strategy.

Now that I’ve explained the basics, you may wonder if short selling is a good strategy for and investor.  After all, why not make money when the market is going down as well as when it is going up.  The issue is that you really don’t know very often when the market will be going down.  You can certainly tell when the market is overpriced, but that does not mean that the market won’t continue to be overpriced, or even get more overpriced, before stocks finally pull back.  Sometime earnings will also increase rapidly, making stocks fairly priced again.

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There are maybe two situations where short selling might be worth it.  The first is called selling short against the box.  In this strategy you sell short shares of a stock you already own, telling your broker that you want to sell short against the box.  He will then borrow and sell some shares, yet leave your original position alone, meaning that you’ll have both a long position and a short position.  When you are ready, you simply tell your broker to wash the two positions and you close both sides.  The reason for doing this is if you want to take a profit in case the stock is about to decline, but want to move the gain into a future year for taxes.

The other time is when the market is really, really overpriced and ready for a fall, or you see something coming like the 2008 housing crisis, and you want to protect your portfolio without selling everything.  In this case, you can take some short positions, effectively going neutral or near neutral on the market, as a way to protect yourself,  For example, in 2007 I was shorting mortgage companies since I figured they would decline when the housing boom ended.

 

 

Have a question?  Please leave it in a comment.  Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Accounts You Need to Have for Financial Security


Today I wanted to talk about how one in general should be allocating funds.  As stated previously, this blog is primarily concerned with strategies to grow funds quickly, assuming that an investor is starting out with little money but working a steady job with a reasonable income.  It also assumes that an individual has scaled her “lifestyle” so that she is making more than she is spending.  This is the most basic requirement for becoming wealthy.  Virtually everyone can scale back to have extra income left over, but it takes a degree of sacrifice and patience since one will need to wait a bit longer to buy things but they will be quite a bit less expensive when one does (because one will be paying cash rather than buying them on credit).

The first place a person should put extra income is in a cash account that is readily accessible.  This should be built up until it contains enough to cover several months worth of expenses.  These funds are used to take care of the various unexpected expenses that occur (such as the car breaking down, heater going out, roof leaking, unexpected surgeries, etc…).  These funds should be guarded judiciously and not spent for things such as vacations, shopping, etc… since these are the funds that prevent you from needing to take out loans or run up the credit cards if something happens.  This account will also be used to live on if one loses one’s job, allowing time to find a good job, not just one taken out of desperation.

                                   

The second account is a retirement account.  This is the money you will live on when you’re ready to retire and also should be guarded carefully.  The only reason to access this kind of account is if you’re about to be out on the street if you don’t.  Absolutely don’t use this money for any other purpose, including taking out a loan against it.  The reason is that if you start saving in your 20’s each dollar will be worth over $128 when you retire, so if you take out $10,000, for example, you just robbed yourself of $128,000 in retirement worth, which translates into $12,000 per year in income.  This account should be filled with index funds when you’re young and gradually be filled with more dividend paying stocks, bonds REIT’s, and cash as you get closer to retirement.

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The third account is your investment account.  This is the account that will use the strategies in this newsletter to grow large, allowing you the financial freedom at some point to work or not work, as you choose.  This account will be invested in stocks starting with 1-3, and eventually growing to 10-20 as your wealth builds to the $500,000 – $1 million range.   Because the money in this account is not critical – you still have enough money to pay for emergencies and fund your retirement with the other two accounts – you can afford to take the risk of one or two of your positions taking a substantial loss.  Also, if you find you are not a good stock picker, such that your investment account does not do as well as the markets, the other accounts will make sure you end up in a good position as well.

Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.