When traders “buy the dip”, they utilize a tactic wherein they buy a stock (among other assets) right after its price falls. This is done because the traders anticipate an increase in the price pretty soon. Traders use the strategy of “buy the dip” for many different reasons. When traders refer to buying the dip, they specifically refer to buying shares immediately after a price drop in order to capture specifically anticipated, generally near-term, gains. In this post, we will take a closer look at the strategy of “buy the dip” and hopefully by the end of the article, a lot of your questions about the topic will be answered. Let’s get started:

Buy the Dip: All You Need to Know

What Is Buying the Dip?

As a strategy, “buying the dip” is quite similar to a trader’s general approach of buying low and selling high on the surface. Unlike traders who specifically look for low prices, traders who utilize “buy the dip” as a strategy look out for these two indicators::

• A sudden or significant decline in an asset’s price
• A specific reason to believe that the decline is ill-founded or will reverse

Generally, traders look for a steep price decline and buy in quickly. With that, they hope to capture the anticipated gains. While a trader can apply “buying the dip” to any asset, it is generally used when it pertains to buying stocks.

What are some examples of Buying the Dip?

Here are some examples of when traders utilize the strategy to buy the dip:

Trend Lines

Stocks usually witness a decline in price after a long term period of sustained growth. Take the example of a firm whose stock trended upward for many months but saw a 10% loss in overnight trading.

In such a scenario, traders will buy the dip based on the overall trend lines of the stock. For those traders, the decline is just a short term aberration in the price of the stock which has grown consistently in the long term. Expecting the trend to continue, traders will buy in.

Random Walks

Stocks tend to jitter. This is known by many names, perhaps most famously the “random walk theory.” Whatever you call it the basic idea is that, regardless of a stock’s trend, over a given day, the price is going to go up or fall down. Once a stock dips, it’s logical to expect it to tick back up and vice versa.

Day traders and other short-term investors may use this as a basis to buy the dip over the course of a given day. They will invest expecting that a quick fall in price will be matched by an equally quick rise.

Emotional Trading

Despite the industry’s veneer of cold numbers and slick professionalism, investors are as prone to emotional decisions as anyone else. This leads, among other things, to overreaction. When traders see other investors unloading their stock, they tend to jump on board. That’s mainly because they fear the losses if they’re left behind by a market movement. Other traders may look for the dips created by these overreactions. For example, say a major mutual fund suddenly dumps all of its shares of a given stock. This also causes a price drop because other traders who are fearful that their rivals have just stumbled across a weakness in the firm. This leads to them dumping their shares as well.

Another trader might make the assumption that a mutual fund is simply restructuring its assets and will buy that dip. It will do that based on the expectation of prices to recover. Yet another one might react to an unexpected event in the news.

Fundamentals Trading

Say that a company is projected to have a strong quarter, yet nevertheless its stock dips. A fundamentals trader always observes  the quality of the underlying business. Some of those things are:

• who manages it
• what does its business plan look like
• how solid are its debt-to-equity ratio and its cash flow management.

A trader who doesn’t believe that falling prices aren’t accurate reflections of future sales might buy the dip. In such a case, traders expect the stock price to bounce back as other investors realize that the currently lower share price doesn’t reflect the actual strength of the company.

What are the risks when you Buy the Dip?

The risk of buying the dip comes in the second indicator of this tactic’s analysis: “A specific reason to believe that the decline is ill-founded or will reverse.”

In a nutshell, even the most sophisticated analysis can’t be certain that a dip is temporary. Whatever your reasons for buying the dip, they’re ultimately because you believe that the price will climb again. While you may be right, but when you buy the dip, you essentially bet against the market temporarily. Hence the risk of getting it wrong is very real.

Most traders mitigate their risk through techniques such as stop-loss orders. Because of this, traders can set a minimum price. If the value of the asset drops lower than that, traders will automatically cut their losses by selling it off. It means accepting a loss, but it’s better than watching your money enter a free fall.

So, we can conclude that when you buy the dip, you use an approach to investing where you buy a security that has just fallen in price on the belief that it will soon recover its value. While this tactic is popular and utilized frequently, it isn’t risk free. Some of the situations where a trader might use this tactic are trend lines, fundamentals trading, random walk and emotional trading. It has also been dismissed by some critics as a type of market timing.