This article will explain the meaning behind the popular phrase, “buy the dip.”
What does it mean?
“Buy the dip” is a phrase that refers to purchasing an asset after its price has been subject to a decline. This concept consists of different contexts and likewise, different odds of working out. It all depends on the situation in which it is most useful.
A number of trades might say they are buying the dips if an asset is in a long-term strong uptrend. They count on the uptrend continuing after the dip or drop. However, there are others who may use the phrase when no uptrend is present. They do, nevertheless, believe an uptrend may take place in the future. Therefore, they are purchasing when the price drops as a means to profit from a potential future rise in price.
More details & Waves
Now that we understand the basic meaning of the phrase, let’s dig a little deeper into what it entails. Following the price drop from a higher level, some traders and investors see this drop as an advantage. This will allow them to buy the asset or add to an existing position.
The very concept of purchasing dips derives from the theory of ‘price waves’. A wave, at its most elementary level, is a pattern of behavior that is apparent by noticeable increases and decreases. They can often be identified in stock price movements as well as consumer behavior. Investors that try to profit from a market trend are doing an action known as “riding a wave.” A very strong movement by homeowners in order to replace their current mortgages with new ones that have better terms is called a ‘refinancing wave.’
In relation to “buying the dip,” when an investor purchases an asset following a dip in price, they are buying at a much lower price. These investors are banking on the market experiencing a rebound, thus they will end up profiting if the higher prices come.
Traditionally, a trading strategy is a method of purchasing and selling in markets. This chiefly goes off of predefined rules that pertain to making trading decisions. Like with all trading strategies, buying the dips does not necessarily guarantee an investor will profit. An asset can potentially drop for a number of reasons. This includes changes to the underlying value of the financial instrument. Even though the price may be cheaper than what it was initially, that does not mean that the asset is a good value.
A stock that goes from being $10 to $8 may present a decent buying opportunity. However, there is an equally good chance that it may not. When there is a drop in stocks, there could be a good reason as to why. These could be anything from a change in earnings to horrible growth prospects. Moreover, it could also be a change in management, poor economic conditions, or the loss of a contract. It may continue to drop, possibly to $0 if the situation proves to be really bad.
By now, the question pertaining to the control of risk should be taken into consideration. All trading strategies and investment procedures should have some form of risk control. In the financial world, management of risk is the process of identification, analysis, and admission or mitigation of uncertainty in investment decisions. In essence, risk control occurs whenever an investor or fund manager analyzes and later tries to measure the potential for losses in an investment. They then take the appropriate action (or inaction) by going off the investment objectives and risk tolerance.
Investopedia editor, Will Kenton, writes that:
“One of the most commonly used absolute risk metrics is standard deviation, a statistical measure of dispersion around a central tendency. You look at the average return of an investment and then find its average standard deviation over the same time period. Normal distributions (the familiar bell-shaped curve) dictate that the expected return of the investment is likely to be one standard deviation from the average 67% of the time and two standard deviations from the average deviation 95% of the time. This helps investors evaluate risk numerically.”
When purchasing an asset after it has fallen, most traders and investors will go on to establish a price for controlling their risk. For instance, if a stock were to fall from $10 to $8, which is why they are buying. However, they also want to limit their losses if they wind up being wrong and the asset continues to drop.
Purchasing the dips is prone to working better in assets that are in uptrends. Pullbacks – which is another term for dips – are a common part of an uptrend. The uptrend will remain intact, so long as the price is making higher lows (on pullbacks or dips) and higher highs on the subsequent trending move.
To provide more information on what a pullback is, it’s a pause or moderate drop within a stock or commodities pricing chart. Specifically, from any recent peaks that occur during a continuing uptrend. Pullbacks share similarities with ‘retracement’ (when a stock either rises or falls versus a trend) or ‘consolidation’ (technical analysis term referring to security prices that oscillate within a corridor). These terms are often interchangeable whenever people use them.
Most of the time, we apply the term to pricing drops that are pretty short in duration before the uptrend resumes. An example of this is a few consecutive sessions. Pullbacks are viewed as being purchase opportunities following a large upward price movement for a security. For instance, a stock may experience a noteworthy rise after an announcement of positive earnings. Afterward, it will experience a pullback because traders with pre-existing positions will take profit off the table. That being said, the positive earnings are an essential signal that suggests that the stock will continue its uptrend.
A majority of pullbacks involve a security’s price transporting to an area of technical support before resuming their uptrend. This includes a ‘moving average’ (technical analysis indicator that filters out “noise” from short-term price fluctuations) or ‘pivot point’ (indicator that determines the overall trend of the market over time). It’s recommended that traders closely watch these key areas of support. This is because a breakdown from any of them could signal a reversal instead of a pullback.
As soon as the price begins making lower lows, the price has effectively entered a downtrend. This is basically when the price of an asset becomes lower over a period of time. The price will proceed to get cheaper due to lower prices eventually following each dip. Seeing as how most traders don’t want to hold onto a losing asset, purchasing dips is frequently avoided. This is especially true when it is during a downtrend. Buying dips experiencing downtrends are probably more suitable for any long-term investors who see value in the low prices.
Investopedia writer, Amy Fontinelle, further explains this idea, referring to it as “value investing”:
“Unlike some investment strategies, value investing is simple. It doesn’t require an extensive background in finance (although understanding the basics will definitely help). Nor will you need to sign up for an expensive subscription service or understand how to analyze squiggly lines on charts. If you have common sense, patience, money to invest and the willingness to do some reading and accounting, you can become a value investor.”
There are five basic concepts when it comes to value investing:
- Companies have inherent value
- Always have a margin of safety
- The ‘Efficient-Market Hypothesis’ is innocent
- Successful investors do not typically follow the herd
- Investing requires diligence and a lot of patience
What is an example of dip purchasing that we can draw from for context and additional information? An ideal one would be the ‘subprime lending crisis’ from back in the mid-2000s. It was during this period that a great number of mortgage companies were beginning to see their stock prices decrease. Leaders like Bear Stearns and New Century Mortgage were experiencing significant and continuous declines on stock prices. An investor who will routinely practice philosophy in buying dips will obtain as many of those stocks as they can get their hands on. This is assuming that the prices will eventually rally and go back to their levels prior to the dip.
With all that being said, it has yet to happen. Instead, both of these companies went on to shut down following the loss of significant share value. For example, shares belonging to New Century Mortgage went down so low that the New York Stock Exchange (NYSE) had to put a halt on trading their shares. Investors who saw the $55 per share stock as a bargain at $45 would find themselves unable to unload the stock a few weeks later when it fell below a dollar per share.
On the other end of the spectrum, between 2009 and 2018, shares of Apple briefly went from roughly $13 to $230. Buying the dips in the midst of this period would have given the holder a very nice reward.
For such a short phrase, there is a lot of context and meaning behind it. There is so much that can be said about dips, so if you wish to know more, this at least provides you with a solid jumping off point.