What is Buying the Dip?

What is Buying the Dip?

Buying the dip is a strategy used by investors and traders that involves buying or adding to an existing long position of an asset during a period of downward price pressure, hopefully with the opportunity for the price to recover. This strategy is commonly seen for assets that are fundamentally sound but have been sold off due to larger market sentiment or overreaction. 

Investors “buy the dip” and increase their exposure to that asset when prices are depressed in anticipation of prices recovering and earning larger returns. Disciplined and prudent investors base their decision on when to buy the dip on careful research and analysis as the downside risk for buying the dip is quite high as the investor is increasing their overall position on that particular asset.

Does ‘buying the dip’ work?

‘Buying the dip’ is a catchphrase, not a strategy. Traders can turn this catchphrase into a strategy by defining guidelines for which dips to buy, when to enter, how to control risk, and how much capital to bet on each trade (also known as position sizing).

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.

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As an example, 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.

Shortcomings of Buying the Dip

While buying the dip can potentially minimize the cost of a position and increase potential returns, it can also result in a scenario where losses are magnified. At times, market participants may overreact when selling a security; however, they also can be justified in their rationale for selling.

Generally, when a security price declines, there is a valid reason why the price is decreasing. For a stock, it can be the result of lower-than-expected earnings, increased uncertainty, or a variety of other reasons. As an investor or trader, it is important to be cautious of buying the dip and have a strong rationale for why the security is mispriced.

Buying the dip is used by many investors and traders based on a preconceived notion that the price should revert to previous levels. However, it is not always the case. There are many examples of companies that have gone bankrupt, which results in stock prices of these companies going to $0/share.

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What is buying the dip and what to watch out for?

A buy the dip strategy is usually aimed at trying to make a short-term profit on a downdraft in a stock, whether that’s as a day trader or a swing trader, who may stay in the stock for weeks or months. Either way, the trader is often looking to profit from a stock that’s been oversold, meaning that it’s declined too much in too short a period and therefore is due for a rebound.

This kind of buy-the-dip strategy is not about buying great companies and letting their business performance drive your returns. It’s all about trying to time the market and get in ahead of other traders and out before investors’ sentiments turn. It’s a tug of war between buy-the-dip traders and sell-the-rip traders, who are looking to unload their stock when it moves up temporarily.

So if you’re buying the dip for a short-term move, you’re trying to outguess the crowd and predict the market’s sentiment. This approach may work sometimes, but study after study shows that actively investing your money ends up losing out to passive, buy-and-hold investing. As the old saying goes, time in the market is more important than timing the market.

That’s the key thing to watch out for if you’re buying the dip – you should expect many trades, if not most, to go against you. You’ll be competing against highly sophisticated AI-powered traders that have every possible advantage available to them. You may sometimes win, but trying to outguess the market by constantly trading is a losing game for most people over time.