A well-known market saying is "Don't try to catch a falling knife." The logic is that when a stock is in free fall, there just isn't any easy way to know how far it will drop before it finds support. Many stocks never come back from a collapse, and that is what causes big losses and wipes out more traders than anything else.
The dilemma of these situations is that they are often where the selling is not justified, and the stocks do come roaring back. They can be great opportunities, but there just isn't any way to know if the free fall is due to fundamentals or just meaningless volatility.
The great danger in these circumstances arises because it is very difficult to manage and limit risk. The emotional reaction is to keep buying and building a bigger position because the market is not reflecting the reality of the situation. Many times that is the case, but when you are wrong, the losses can be very significant.
If you are going to try to catch a falling knife, the key is to not let the position grow too big, too fast. Large institutional investors will make incremental buys over an extended period of time and keep trying to lower their cost basis in those names in which they have conviction.
Individual investors with limited capital don't have the luxury or ability to make dozens of incremental buys. They tend to rush in too early and too fast and then will panic sell when the bounce doesn't come fairly fast.
The best way to handle these situations is to set hard stops and take the loss early and then look to rebuy as things develop further. It is important to forget your prior exit point. It doesn't matter if it is higher or lower. The focus should be on trying to buy when a bounce develops. I often will be stopped out and rebuy numerous times when looking to catch a turn in a stock. It is the only way that risk can be controlled.
One stock I'm using this strategy with right now is Forte Biosciences (FBRX) . Forte is scheduled to announce some key data on its drug for the treatment of atopic dermatitis. Preliminary data looked very good, and if that is confirmed, then there should be substantial upside potential.
The stock trades very thinly and is jerked around quite a bit. It was added to the Russell 2000 on Friday, and that caused some additional volatility.
I'm playing the knife-catching game with FBRX and expect that it will continue to be a very volatile trade while we await data at some point in the next few months.
Is there some unknown fundamental issue that is causing the current poor price action? It is possible and that is why risk has to be controlled.
