Buy the Dip Meaning

‘Buying the dip’ is one of the most popular mantras in investment circles. It means buying an asset, like a stock, when the price has declined. The inherent belief is that the price dip represents a bargain on the underlying asset. You will stand to widen your profit margin when the price recovers to the previous high or even overextends it. Generally, buying the dip is usually in reaction to short-term price changes, and it is considered a market timing strategy rather than a long-term investing plan. 

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Nonetheless, it can be applied in both short-term and long-term markets. The size of the ‘dip’ depends on an investor’s sole strategy parameters, but overall, the bigger the dip, the higher the potential rewards. 

The most significant source of risk when following this mantra is that a dip may not necessarily represent a pullback in the market and may otherwise be an underway reversal. So, the big questions are what to look for when buying stocks, and how do you know when to buy stocks?

Buy the Dips Strategy – How Does It Work?

Markets never move in straight lines, which validates the buying the dip strategy. Prices tend to move cyclically, with several up and down movements happening within longer-term trends. 

The objective of a buy the dip investor is to look for cyclical low points that will likely provide optimal price entry points in the market and exit in cyclical high points. This is referred to as ‘buy the dip’ and ‘sell the rip.’ 

Different market cycles, buy the dip investors can look to, so they can time the market for entries. There is a 4-phase market cycle of accumulation, markup, distribution, and decline. Here, buy the dip traders can look to enter trades during the accumulation phase and sell during the distribution phase. 

There is also the 3-phase bull trend based on the Dow Theory, where traders will look to enter the accumulation phase, hold their positions throughout the public participation phase and sell during the excess phase. 

Both fundamental and technical factors can detect market cycles. There is the general fundamental 2-phase business cycle of overall expansion and contraction of the economy. Some of the fundamental indicators that can track the business cycle include employment numbers and GDP. 

The subjective psychological phase of greed and fear can be tracked using different technical indicators in the markets, such as Fibonacci tools. When cyclical trading stocks buy the dip, investors can also look at calendar cycles to time their entry points in the market. 

Market cycles can play out in the short term or the long term. The biggest frustration of the buy the dip stocks strategy is that there is no universal way of quantifying the frequency and magnitude of any dip in the market. While looking at a chart in hindsight may highlight many buy the dip opportunities in the market, it is complicated to identify the best opportunities in a live market scenario. 

Does Buying the Dip Work?

Like every investing strategy, buying the dip has both advantages and disadvantages. The most compelling case for buying the dip is that it offers high-profit potential. In an uptrend, buy the dip investors outperform buy-and-hold investors unbothered by price peaks and troughs in the market. 

Market dips always happen, and they will always be opportunities to get a bargain. Buying the dip also helps long-term investors to lock in a low average price of their favourite assets. This also contributes to widening your profit margin. 

The strategy is also ideal for trading certain types of markets prone to high-value dips over time. Some stocks that offer valuable dip opportunities include technology stocks, cyclical stocks such as hospitality and commodities, and growth stocks that tend to be very volatile. 

Finally, there is also the psychological ‘kick’ of earning a discount in the market. At the very least, buying the dip will give you the peace of mind and excitement that you did not buy an asset at its most expensive price. 

But buying the dip or instead timing the market is an inherently risky affair. It is especially very difficult to quantify the magnitude of a dip. There may be reasons behind a dip, and you may get trapped in a full-blown bear market. The reverse is also true. You may also lose out on substantial gains in a strong uptrend by waiting for a dip in the market. In general, it is challenging to differentiate between a temporary price pullback in the market and the onset of a downtrend. 

Risk Management When Buying Dips

The most significant risk when buying dips is that prices will continue falling. Here are some tips to minimize risks when trading the buying the dip strategy:

  • Use stop losses – When buying dips, it is essential to use hard stop losses to prevent amplifying losses if a bull market has reversed. For instance, if a stock falls from $50 to $40 and you decide to buy it, you can place a stop loss at $30 to cut your losses if the bear trend continues. You can place a stop loss at levels that qualify a bear reversal. After a percentage move, this can be below significant support levels or higher lows. 
  • Buy dips during confirmed uptrends – Buying dips works best during confirmed uptrends in the market. This strategy should only be deployed when the price is making higher highs and higher lows. As long as the price persists higher, you can look for the best opportunities to ‘buy the dip’ and ‘sell the rip.’ 
  • Combine buying dips with other strategies – When buying dips, a major risk is pinpointing the optimal price to place an order. It is, therefore, important to time dips by incorporating other strategies in the market. For instance, you can place a buy order during a pullback when the price reaches the 38.2% retracement level. Looking for confluences of different strategies when buying the dip can help pinpoint optimal price entry points in the market. 
  • Implement dollar-cost averaging when buying dips – Dollar-cost averaging involves buying smaller amounts of stock at regular intervals. This strategy can complement buying dips and help investors limit both upward and downward risks in the market. You can buy both small and big dips in the market over time. When the price moves significantly lower, you will gain a lower average price, and you will also not miss out on big gains if there are only small dips in the market that do not meet your entry criteria. 

Final Words

Buy the dip is not just a fancy mantra. It is a recognition that an asset’s price moves in cycles, and there will always be opportunities to hunt bargains in the markets. Nonetheless, it is never an easy task timing the market. 

It is, therefore, vital to understand and beware of the risks involved when buying dips. By implementing effective risk management plans, buy the dip investors can be exposed to lucrative opportunities in the market.

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FAQ

  • What does buy the dip mean?

    Buying the dip means buying an asset when the price has declined. The hope is that price will recapture its previous high or exceed it.

     
  • Is buying the dip a good strategy?

    Buying the dip is a good strategy that helps investors maximize profits by finding ‘cheap’ prices in the market. However, traders should be careful in timing the market.

     
  • When should I buy a dip?

    It would help if you ideally bought a dip during a confirmed uptrend. This will ensure you widen your profits and limit your risks in a trending market.

     

** Disclaimer – While due research has been undertaken to compile the above content, it remains an informational and educational piece only. None of the content provided constitutes any form of investment advice.