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It can be challenging to know which strategy to choose when investing in the stock market.
Should You Buy the Dip? 4 Tips to Increase Your Chances for Success
What is “Buying the Dip?”
The concept of buying the dip revolves around purchasing a stock after its average price has dropped significantly in value. In theory, these investments offer the opportunity to buy stocks at a lower price before riding the wave back to higher share valuations. Such a move allows a trader to sell high or hold assets for long-term growth.
No set amount of loss constitutes a dip, leaving investors to decide for themselves which stocks to invest in. A slight price drop has less risk but doesn't carry as much upside potential. Conversely, a significant fall in share prices enables the purchase of more shares, but such shares may never return to their previous high.
How Does It Work?
The buy the dip strategy works by setting aside funds and searching for a stock or other asset class having a rough stint on their perspective markets. Once an asset drops by a certain amount, long-term investors take advantage of lower prices to buy more than they could before.
Assuming stock prices return or exceed expected price levels, investors can walk away with more money than those who invest at other times. Stocks may take time to climb out of dips, and some may never see higher prices. It's important to know what to watch before investing in this strategy.
What To Look For Before Buying the Dip
There's no exact science to uncovering dips, but there are some signs to watch for before buying. As a stock or other asset trends downward, share prices give way to lower highs and lower lows with each passing day.
Watching this trend helps to know when the price drops far enough to buy low. Although sometimes a guessing game, a good dip strategy waits for low and high prices to start trending upward again.
Tools like the Chaikin Money Flow (CMF) value study these moving averages over time to indicate the right moment to buy the dip. Even so, no data will be right 100 percent of the time.
Dip buying is more than just asset or stock prices, though. External factors can play into price drops, and having the right strategy can make a significant difference. No amount of market research guarantees gains, but doing your homework can help manage risk.
4 Tips for Buying the Dip
Before you begin your quest to buy the dip, consider the following tips to give yourself the best chance at success.
1. Follow Market Cycles
The stock market behaves like a living, breathing entity that changes over time. While stocks themselves see ups and down, so too does the market as a whole. When doing any kind of trading, it's helpful to understand the market's state and its effect on individual stocks.
Analysts identify four phases that markets cycle through over time. Markets can be in a phase of the cycle for any time, be it weeks, months, or even years. Keep in mind that no stock is sure to follow the market's direction as a whole.
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At some point, the market falls into a dip of its own. As things pick back up, watchful investors start picking up the pieces. While things may feel bearish at the onset, upward trends begin to emerge. Shares sold for a loss start getting bought back up, and the market comes back to life.
Because overall sentiment toward the market is still down, investors can find it challenging to identify when this phase begins. Traders may still be selling at a loss, trying to stop the bleeding from getting any worse.
This could be a very lucrative time to purchase shares if the asset you're investing in rebounds quickly.
During the mark-up phase, markets start gaining more traction, and some dropped stock prices experience a renaissance. Higher high and low price numbers become more prevalent, and frequent buying continues to push things higher.
Any stock price that is slow to recover may still offer an opportunity for buying the dip. Since the market's overall trend is upward, investors may keep an eye out for a drop in a particular stock's price as another chance to buy the dip. Such stocks may have a better chance to bounce back as the market continues to climb.
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The mark-up stage gives way to a distribution period as the market reaches its peak. Investing uncertainty can happen here, as traders may still be under the belief that the market will rise further. Sensing the risk, sellers unload investments and wait for the next accumulation cycle to begin.
Those who play more for the short term show their selling prowess here to unload before the market dips. There's still a lot of trading happening, but eventually, sellers win out, and the market begins to fall into decline.
As decline sets in, many short-term investors who did not sell during distribution start trading here to maintain profit targets. As the market falls, it brings the value of most stocks with it to a lower price.
The end of the decline phase is often quite hazy, resulting in additional risk for anyone looking at buying. Attempting to buy the dip during a decline can lead to a further price drop instead of a good value.
Those able to perfectly time out an investment strategy can capitalize on a decline phase-shifting back into accumulation. Dip buying at this point can lead to additional shares for a low price when dips are at their greatest.
Not Every Stock is the Same
It's well worth doing extensive research on potential investments before taking the plunge. While it may make sense to consider buying a stock that's had a massive drop in share price during a decline, it's possible for an asset to never recover from a downturn. Companies may go out of business entirely or simply not rebound when the market does.
For example, the dot com crash from the early 2000s wiped out many fledgling tech companies valued high before demand waned. These ventures couldn't support themselves when markets fell into a prolonged recession.
2. Look for Outside Factors
There's a big world out there that plays a massive factor in asset price swings. In 2020, nearly everyone on the planet was swept up in a global pandemic that wreaked havoc on economies.
Many stocks felt the effects of the Covid-19 outbreak and dropped in price significantly as a result. Above that, many businesses were unable to survive the experience. Some assets could regain lost shares quickly, while others have yet to do so.
Staying at the forefront of these happenings will help develop a strategy to buy the dip when these events occur. Traders who successfully predicted stock price rebounds could do well for themselves.
A similar example is the stock market crash during the financial crisis of 2007 and 2008. The United States plunged into a recession that sent and kept stocks down for a considerable time.
3. Dollar-cost Averaging
Some investors may consider dollar-cost averaging during stock dips. Like a retirement plan, dollar-cost averaging sees traders making regular, intentional investments during a dip. Buying in such a way helps mitigate the risk of investing one lump sum too early.
Even if the price continues to fall, dollar-cost averaging helps to ensure that your losses are minimized before the stock recovers from the dip. This strategy may work well for individuals who can't watch shares closely for the perfect time to invest.
4. Don't Invest Money You Need Today
Buying the dip can result in fast returns, but this often isn't the case. Rather than panicking and selling for a loss, it may be worthwhile to let the stock simmer to see if the price comes back up over time. Sometimes, you may add shares to your portfolio before they've bottomed out.
Even when a stock does recover, the timing is always unknown. When possible, it's better, in the long run, to give the asset space to breathe and do its thing.
Should You Buy The Dip?
Buying the dip has the potential to be a solid moneymaker when it comes to investing in stocks, mutual funds, ETFs, cryptocurrency, and the like, but it is not for the faint of heart.
While appearing as an opportunity to buy and sell quickly, several variables can affect how quickly an asset rebounds – if it ever does at all. As such, short-term traders probably won't mesh well with buying the dip.
A thorough understanding of a potential investment is essential before making a move, whether you're looking to buy the dip or not. A downward trend could be a company in bad shape that's on its way to boarding up its doors for good.
Most investors who do buy the dip focus on a long-term strategy and expect to be with an asset for a while. It may be a bonus to purchase additional shares while low, but that is not the ultimate goal.
Advantages and Disadvantages
The obvious advantage of buying the dip is the acquisition of more shares of an asset for a lower price. This benefit needs to be weighed against the limitations when you buy the dip.
Discovering the bottom of a dip is incredibly difficult to do, even when watching the numbers carefully. It's all about timing, and a misstep could result in a loss instead of a gain.
There's never any certainty that an asset will recover from a dip, especially when the company it represents has issues. If these problems are not overt, you could find yourself investing in a company that will only drop further.
If a stock has a dividend, waiting and watching for the perfect moment to buy the dip could spell a missed opportunity at passive income.
When to Buy the Dip: Final Thoughts
Buying the dip is a means of making the most of an ever-changing market. A sense of pride comes with picking up an asset when it's at a low and watching it rise to glory.
These considerations can play into the direction an asset will move at any time. That being said, it takes a keen mind to discover the right moment to make that investment. It requires a lot of research on the asset itself and the shape of the markets and the world around us.
Anyone planning to pursue a buy the dip strategy should take a long-term approach to maximize the chance of success. Only you can decide if the risks are worth the potential outcome.
Noah is an American copywriter on a mission to help clarify the nuances of the financial world. With a background in tech design, Noah is no stranger to numbers and financial data. He now uses these powers for good by writing reviews for The Stock Dork. When he’s not working, you’ll likely find Noah out running or traveling.