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Here's Why Buying On The Dip Has Been Working

|Includes:SPDR S&P 500 Trust ETF (SPY)

Here's Why Buying on the Dip Has Been Working by Market Authority

B.F. Skinner created the operant conditioning chamber (aka the Skinner box) as a grad student at Harvard in the 1920's. Now widely used by college psychology students everywhere, this apparatus allows the experimenter to study behavior conditioning by teaching a subject animal to perform certain actions (such as pressing a lever) in response to stimuli (light or a signal). Upon completing the desired behavior, the Skinner box can deliver a reward (such as food or water). In less ethical apparati, the subject can be punished through a device such as an electric grid.

Here's what a Skinner box looks like…

Buying on the Dip

In this example, rats can be trained to respond to a green light by pressing the response lever and food will be dispensed. The contingencies in the rat's environment can shape its behavior.

Why is this important to know? Because the behavior of investors is no different. Investor decisions are based on recent contingencies in their environment. (There are other less observable factors that shape buy/sell decisions, but operant conditioning is the most simplistic).

When investors are strongly rewarded for a particular behavior, they will continue that behavior even when conditions change. Just as the rat will continue pushing the lever even if the reward schedule changes.

This is why bull and bear markets tend to overshoot and last longer than investors expect. Or as Keynes put it, "The markets can remain irrational longer than you can remain solvent." To see how operant conditioning is working in our current environment, just look at how richly dip buyers have been rewarded in the 2 year chart of the SPY

Buying on the Dip

You can clearly see that every selloff has been followed by higher prices, rewarding those who buy on dips. Right now, the bulls are clearly in control of price action, and bears have been punished. Since the environment has favored the bulls for nearly 2 years, it becomes more difficult to change the trend. When the market does turn bearish, we will see a sequence of lower highs and lower lows as the dip buying rewards decrease. This is why topping is a process, and doesn't occur as a 1-day event. It takes much longer for the dip buyers to change their behavior.

If you look in the last few months, the selloffs have been shallower- perhaps the buying on dip rewards are already becoming smaller. Will the decrease in dip buyer rewards lead to different dip-buying behaviors in the future?

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