“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.
"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 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.
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 includes:
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.
Bottom Line
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.
Source: seekingalpha.com