To The Moon

Buy low, sell high, sounds familiar?

Dips or pullbacks are common occurrence in uptrends, so the term ‘buying the dip’ refers to the practice of buying an asset after it has declined in value, hopefully with some research that indicates it is likely to rise again following the dip.

Buying the dip can be profitable, but there are no guarantees that any single trade will work out. Moreover, this drums up FOMO — or fear of missing out — a state of mind that can encourage some people to ‘buy the dip’.

A catchphrase among traders

A dip doesn’t have a fixed value attached to it. To a day trader, a dip may be a pullback of 1% from a recent high. A longer-term investor may consider a drop of 20% a dip. Therefore, ‘buying the dip’ is a concept, and only becomes a strategy once some personal rules are put in place regarding how to define and trade a dip.

Some traders feel that the further a stock or asset has dropped, the more upside potential the trade presents. That can sometimes be true, but other times an asset’s price keeps dropping. Therefore, risk-management is key if you’re trying to buy the dip, as is deciding when to take profit if the price does rise following the dip.

Short-term traders will typically look for small dips and small bounces. They may not be in the trade for big moves over long periods of time. On the other hand, investors may look for bigger dips to buy and then also try to hold the trades for years, potentially capturing large upside moves.

The S&P 500 index (or related ETFs) is commonly used for a buy the dip strategy. This is because throughout its history, it has consistently recovered to new highs following a dip. That said, it can sometimes take years for this to happen.

Trend is your friend 

The rationale is that if an uptrend continues, the price of a stock or asset will eventually move to a higher price than it traded at prior. During an uptrend, pullbacks or dips are a common occurrence. And while the uptrend lasts, pullbacks are followed by higher prices. The risk is when the uptrend ends, because prices could go significantly lower or take many years to recover to prior levels.

Buying the dip is best combined with additional analysis or strategies. Trend analysis is a common tool to combine it with. When there is an uptrend or bull market, meaning that the price of the asset is making overall higher swing lows and higher swing highs, it is conducive to buy the dip. The price isn’t dropping below prior low points and is instead making new highs following the dips.

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Buying the dip may work when losses are cut to avoid taking a big hit, because sometimes a dip keeps dropping. Cutting losses handles the risk aspect, but not the profit aspect. Buy the dip traders may also want to consider holding onto winners long enough that their potential profit is bigger than their potential loss. This is known as weighing up risk/reward ratio . Traders can apply stop-loss orders and set profit targets to construct a level of risk/reward that they are comfortable with.

Ways to manage risk include placing a stop-loss order on each trade. A stop-loss is an order type that exits a trade at a certain price or if a certain amount of money is lost. Stop-losses are placed at a point where the order shouldn’t be touched if the trader is correct in their timing of the market, or where the trader is only risking a small percentage of their account value.

Traders and investors also manage risk by spreading out their capital across multiple stocks, not just one or two. This ties into position sizing: limiting how much capital is put into each asset. If an asset falls in value more than is expected, the loss shouldn’t significantly hurt the whole portfolio.

Managing risk is important, whether buying an asset on the rise or during a decline. The main downfall of the buying the dip is that the price may keep dropping, resulting in an expanding loss, aka catching a falling knife.

Warren Buffett’s favourite S&P 500

Although buying the dip has been shown to work over the long-term when trading on indices. The S&P 500 tends to rise over the long-term, so buying the dips can be turned into an effective strategy. Yet, traders must realise that even with index dips, sometimes these may turn into crashes.

Traders either need to be willing to hold until prices move back above the entry price — which can take many years — or cut losses as the drop gets bigger. When it looks like the price may start rising again, this could be an opportunity to get back into the trade in several tranches, not all at once - by averaging up.

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