What Does “Buying the Dip” Mean?

Investment 101

Published: May 8, 2022

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The stock market is a collection of exchanges where investors buy and sell shares of companies. The price of stocks, the liquidity, and the volatility of the overall market are driven by supply and demand, as well as by economic triggers that cause prices to rise and fall. 

Sometimes, different factors combine to create great volatility in these markets. Stock prices may move up and down quickly. During these changes, the price of the stock may not reflect the value of the company. You may see instances where a company with good financial data sees its stock price fall in the short term. If the underlying fundamentals of the company are still strong, this dip in share price is usually temporary. 

Some investors and stock traders use a strategy called “buying the dip” to take advantage of these temporary discounts on quality stocks. The theory is that the factors causing the downward price movement will eventually disappear and the stock will move back to a fair price. 

Understanding Buying the Dips

Buying the dip is a way to get stocks at a discount. The general mindset is that exterior factors cause the share price to fall, but because the company remains strong, these downward movements are temporary. 

An investor can look at a company’s balance sheets and income and cash flow statements to verify that no fundamental flaws are causing the price drop. Some traders use the Elliott Wave Principle, or Wave Theory, which suggests a natural pattern of dips and surges in stock prices. The theory suggests these highs and lows surround a central trend. Elliott Wave is a kind of technical analysis, so traders use it to define dips. It’s not an exact science, but it can give investors insight into probable price movements. 

What does a buying-the-dip strategy mean for your portfolio? It can allow you to purchase stocks for a discounted price and help you build a portfolio for less money. If you correctly identify the bottom of a dip, you can get a better-than-average return. You will profit from the long-term, upward trend of the stock, plus any extra profits from the dip below the average. 

Managing Risk When Buying the Dips

Like every trading strategy, buying the dip comes with inherent risk. The average investor may miss economic signs or data about the company that could signal the beginning of a downtrend. Even the inventor of the Elliott Wave Principle stated that it was based on probabilities and was not a sure indicator of dips, price averages, and surges. 

Because there are risks when buying the dip, you need to have proper risk management practices in place, including:

Diversification

Asset diversification involves obtaining different types of investments in different sectors. The goal is to avoid having a single economic event affect all your stock, commodity, bond, or real estate holdings. 

The best investments for diversification may include stocks in different sectors and precious metals like gold and silver. Gold is a popular haven in bear markets when stocks typically go down in value. It would go up in value or hold steady, negating some of the stock losses. 

Other investments, like cryptocurrency, collectibles, real estate, and bonds can add other elements to your portfolio to stabilize it. 

Knowing Your Risk Tolerance 

Another important step is to understand your risk tolerance. This is the amount of money you are willing to lose as you pursue investment profits. Even with the best research, you cannot predict the bottom of a dip with 100% accuracy. 

Whether you work with a broker or on a self-directed investing platform, you can use stop-loss orders to manage risk. These orders will only trigger when a stock reaches a predefined amount of loss. For example, if you purchase the stock at $20 per share, and your risk tolerance is $5 per share, you would set a stop-loss order to trigger at $15. 

Patience 

Buying the dip can be profitable if a stock or other asset is in a long-term uptrend but experiencing a short-term downtrend. Patience is required to find these opportunities. You need to analyze both technical and fundamental aspects of the price movement and wait until signals tell you that it’s time to purchase. 

On average, major indexes like the S&P 500 experience one pullback or so per year. Depending on the time frame you look at, dips that return to the normal price are relatively rare, so patience is a necessity to take advantage of this strategy. 

How To Start Buying the Dips

Even if you have the best risk management strategy in place, timing the market on your own is naturally going to be risky. You could potentially buy into a stock that continues to dip for the long run. That being said, if you do start using a buy-the-dip strategy to trade stocks or other assets, it can help build your portfolio.

Watch First

Buying the dip strategies work if a stock is on a long-term upward trend and the short-term price falls are part of a pattern. Rather than acting on emotion and jumping in as soon as a stock drops below its long-term moving average, you need to watch its movements before you make a purchase. 

If you use the Elliott Wave principle to try to confirm a dip, you need to look for specific patterns. The theory suggests that there are smaller subsets of waves that make up a larger up or down price movement. Each of these sub-waves has a different amplitude and following the pattern can help you find the bottom of the price dip. 

You can also confirm the dip with other technical indicators like the relative strength index (RSI), which shows whether a stock is overbought or oversold. The bottom of a dip will usually occur when a stock is oversold.  

Watching and waiting can help you see all these indicators and patterns. You can use different types of technical analysis to confirm the dip and the long-term average. If you get multiple indicators telling you the same thing, you can be more confident in your decision to buy. 

Work With a Broker 

You can also work with a broker to help make the trading process smoother. Self-directed platforms offer access to financial markets, but they provide little guidance. However, a broker can guide you if necessary and help you achieve the desired result. 

Buying stocks, gold, options, or other assets is a non-refundable activity. The market isn’t going to return your money because you bought when you meant to sell or purchased more shares than you planned. A broker can help you avoid these errors, at least until you gain more experience as an investor.

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