'Buying The Dip': What It Means & How To Do It
“Buying the dip” is a phrase that describes investment strategies designed to take advantage of the cyclicality in stock prices over time. Learn what buying the dip means and how traders do it.
What Does It Mean to ‘Buy The Dip’?
"Buying the dip" refers to the act of buying stock (or adding to positions) on a decline that meets certain parameters. A simple parameter might be to purchase when a stock or the broader market index has dropped more than a certain % from a recent peak. (This scenario is depicted in the example below.)
However, buying the dip can also be less of a specific instruction and more of a general statement of confidence that the uptrend should continue and not to sell at this time. It is a natural tendency tied to loss aversion bias for many investors to get nervous and to consider selling when stocks begin to decline, despite the fact that minor declines are common occurrences, even within long uptrends. For these people, buying the dip would represent a statement affirming the longer-term uptrend and an opinion that it is not a good time to sell.
'Buy The Dip & Sell The Rip'
For someone who is looking to trade or invest in concert with market cycles, buying the dip would just be one part of the strategy—acquire stocks in or near the trough in the cycle. The other part of the strategy—“sell the rip”—refers to selling stock at an assumed peak in the cycle. To "buy the dip and sell the rip" describes a complete timing strategy for an investor who is interested in trading the cycles.
Example of Buying The Dip
The chart below shows the S&P 500 index over the last 10 years with red circles indicating the periods where a 10% decline had occurred. An investor who was buying 10% dips would have purchased when the market was down 10%. This will have proven beneficial for most of the last 10 years, but the problem is that one may not know that the long-term trend has broken until the index has gone down say 20%. That means that the investor would take a loss on purchases made at the -10% level when the trend finally breaks into a downtrend.
Tip: Buying the dip should be associated with a patient, long-term approach to stock investing. Trading market cycles should be a strategy for short-term or swing traders who have analyzed various techniques and who are prepared to trade based on disciplined indicators.
Understanding Market Cycles
To understand the "buy the dip" strategy, it's important to first understand market cycles. Neither individual stocks nor the market as a whole move in straight lines—both tend to move up and down over time within longer-term trends. Charles Dow, the founder of the Wall Street Journal and the indexes that bear his name, was one of the first to describe stock market cyclicality over 100 years ago.
Since that time, market technicians have attempted to use a variety of market cycles, patterns, and technical indicators to devise trading techniques that could outperform the market by taking advantage of such movements. The objective is simple: to enhance overall market returns by purchasing when a stock or the market is at a cyclical low point and selling when the market is at a cyclical high point. In reality, however, the ability to outperform the market in this manner has proven to be much more elusive than people thought and much debate has ensued as to its merits.
Part of the challenge is defining and quantifying market cycles, as there are many different versions that are used. There is the:
- General business cycle: varies from expansion to contraction in the overall economy
- Four-phase cycle: accumulation, markup, distribution, and decline
Others have defined market cycles in psychological terms describing vacillations in terms of repeating periods of panic and euphoria. In addition, there are:
- Wave-based cycles
- Calendar cycles
- Sector rotation cycles
- Presidential cycle
In sum, there are as many different ways of buying the dip as there are different types of cycles and no universally accepted way of identifying the frequency, magnitude, or regularity of opportunistic dips in stock prices. This renders the term somewhat ambiguous and subject to the interpretation of the user. The growing popularity of passive investing through index funds speaks to the frustrations of many investors who have thrown in the towel on trying to outperform the market by timing purchases and sales with any consistency.
How Long are Market Cycles?
As you might expect, the cycles mentioned above differ greatly, not only in what they are based on but in their frequency and duration. Many take months or years to play out. That makes it quite challenging to know when a dip in price is presenting you with an attractive buying opportunity or when it is only the beginning of a cycle downward that might take months before rising again.
It is easy to look at a price chart, identify previous dips in price, and conclude that if you bought into those dips, you would have been able to get a leg up on the market as it rises again within the long-term trend. But that confidence comes from the perfect hindsight one has when viewing a price chart. On the occasions when those dips were occurring, you wouldn’t have that knowledge and would constantly be faced with the dilemma of whether it was truly a good time to buy or whether the market was breaking into a longer-term downtrend.
Behaviors The Cause Market Cycles
Market cycles may not be regular or predictable, but there is little question that they are real and recurring and there are a host of proposed rationales for their existence. Some are based on economic theories about supply and demand or the natural ebb and flow of business prospects over time. Others are purely based on mathematics and calendar periods that have shown a propensity to correlate with the ups and downs of the market.
Nonetheless, the widely accepted premise for most cycles lies in the assumption that they are linked to the emotions of market participants or to cognitive biases such as fear of regret and overconfidence. Dow’s early observations likened the market to a barometer of the collective optimism or pessimism present among the investing public. More recent interpretations link the market to the degree of fear or greed present among investors.
'Peak & Trough' Metrics
Over the years, market technicians and cycle proponents have put forth hundreds of measures and indicators that investors can use to guide decisions about buying dips and selling peaks. No single indicator can be expected to provide an iron-clad assessment as to whether the market is at a peak or trough but taken collectively, they can often provide valuable insights as to whether the market is presenting an opportunity to buy or sell stocks at attractive prices.
Types of market indicators include:
- Economic indicators
- Price and momentum indicators
- Options indicators
- Volatility measures
- Demand for bonds over stocks
- Level of margin debt
- Sentiment indicators
- Technical indicators
CNN has created its own Fear and Greed Index from seven specific indicators, including:
- The S&P 500 versus its 125-day moving average
- The number of stocks hitting 52-week highs and lows on the New York Stock Exchange
- The volume of shares trading in stocks advancing versus those declining.
- The options put/call ratio
- The spread between yields on investment-grade bonds and junk bonds
- The VIX, which measures volatility
- The difference in returns for stocks versus Treasuries
Tips on How To 'Buy The Dip' While Mitigating Risk
A few examples of strategies one may implement to help them "buy the dip" while mitigating risk include:
- Always keep the longer trend in mind. Buying dips may work best when the longer trend is up.
- Establish parameters or indicators in advance for deciding when to buy. Decisions are much more difficult when declines occur.
- Use limit orders to acquire stocks at your price objectives. That way you can put a buy order in at a lower price and either get your price or not execute a purchase.
- Sell put options on stocks you wish to buy at lower prices. That way, you receive a premium from the put regardless of whether you get to acquire the specified stock at your target price or not. This is a more advanced technique.
Important: The above are examples of strategies one may implement and not suggestions on what an investor should do. Always consult with a trusted financial advisor when making investing decisions.
Buying the dip essentially recognizes that stocks cycle up and down within longer-term uptrends and that, in that context, declines within the trend can be seen as buying opportunities rather than selling situations, as long as there is confidence in the trend.
The dip is a short-term decline inside a longer-term uptrend.
There is no magic answer to this, but numerous technical indicators can be used to help determine the optimal buy point within a dip.
Buying declines within a longer uptrend can prove beneficial, but there is no guarantee and investors should not expect that the strategy will always be successful.
This article was written by
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours.
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