A catchphrase among traders, “buying the dip” refers to the practice of buying an asset on its declined value only to sell it once the price has reached a new high. In this article, you’ll learn how to apply the strategy and when — as well as when not to apply it. Buying the dip can be profitable, but there are no guarantees that any single trade will work out.
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The term ‘buying the dip’ refers to the practice of buying a stock or other asset after it has declined in value, hopefully with some research that indicates it is likely to rise again following the dip. Dips or pullbacks are common occurrence in uptrends, so the strategy may have merit for those who know how to use it.
This drums up FOMO — or fear of missing out — a state of mind that can encourage some people to ‘buy the dip’.
The concept is centred around buying (going long on) a stock, index, or other asset after it is has declined in value. The hope is that buying it at a lower price than what it has traded at in the past may be a bargain, and a profit can be made if the price moves higher following the dip.
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 (risk and profit taking are discussed in more detail later).
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.
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.
There are a few reasons why the buy the dip strategy works and why it is popular at certain times, which are explained in more detail below:
When the central bank is printing money or increasing the money supply, this is generally good for stock trading. More money floating around means more of it finds its way to the stock market and other assets.
In this case, it is still important to follow the trends, because how people spend money may change over time. Housing prices may boom, or stocks may rally, or bonds, or commodities, or all of them. If you are reading about central bank stimulus in the news, then quite often there will be some assets benefiting. Those assets tend do well with a buy the dip strategy because the asset is being backed by an increasing supply of money to keep pushing it up.
Increasing the money supply means more currency in circulation, which can push down the value of the currency, which will have implications when forex trading. If many countries are increasing their money supply, consider who is increasing it the most or the least.
Market stimulus is like central bank stimulus. A market is being stimulated into growth. For example, corporate tax cuts could be a form of a stock market stimulus, or a reduction in consumer taxes.
Lower taxes for corporations can result in higher profits. Lower taxes for consumers means that there is more money to spend, increasing corporate profits, or more money to invest, which pushes up stock and other asset prices.
In a market stimulus environment, many people employ a buy the dip strategy because the uptrend is backed by favourable news, which may continue driving prices higher.
Another reason traders use ‘buy the dip’ is because of mean reversion. Mean reversion refers to how a price fluctuates around its average price. Prices don’t move in straight lines; they rise above and fall below their average price. When the price dips, traders may buy hoping the price returns to its average or above. The idea is to buy low and sell high, compared to the average or mean price.
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.
When this uptrend pattern falters, and the price starts hitting lower highs or lower lows, the buy the dip strategy may not work as well, because now the price is moving in an overall downtrend.
Buy the dip can also be combined with a daily moving average or other technical indicators to signal when a dip may be ending and the gains resuming.
Warren Buffett is a long-term buyer of stocks. His intention is to buy and hold if he likes a company. While he doesn’t always buy on dips — he prefers stocks that present long-term growth potential — he has been known to add to positions when a stock pulls back.
Buffett has a list of stocks he has researched and is interested in, and he then buys those companies when the price is right. Sometimes this may only happen on a dip.
‘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.
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.
A catchphrase related to ‘buy the dip’ that is also commonly used by traders is ‘catch the falling knife’.
While ‘buying the dip’ typically refers to the practice of buying an asset that is in a strong uptrend when it pulls back, ‘catching a falling knife’ more commonly refers to trying to buy a bottom in a stock or other asset that is falling hard. This is considered far riskier than ‘buying the dip’, as the sharp fall may continue, while dip buyers may wait for some price consolidation before they start to buy.
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.
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.
For example, if a trader believes a stock will only fall 10%, they may buy near this level, and then place a stop-loss a few percent below this. If their analysis is correct, the stop-loss won’t be hit. But if the price keeps dropping, the stop-loss order keeps the loss from getting bigger by closing out the trade.
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.
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A price drop isn’t the only time to consider buying a stock or asset. Traders may choose to buy when prices are moving up, breaking to new highs or out of chart patterns.
Some traders prefer to buy as prices are rising, because a rising price shows the buying interest is there right now, although it is unknown how long this buying will last before a price dip or drop occurs.
Methods for buying as prices are rising often include some sort of breakout. This may be a breakout to a new high price. This could be a yearly high, an all-time high, or the price moving above a recent high on any chart time frame.
Traders also watch for buying breakouts by using chart patterns such as triangles, rectangles or ranges, and cup and handles.
