Buying the dip is a tactic in which traders buy an asset, usually a stock, immediately after its price declines, anticipating that the price will go back up in the near term. There are many reasons why a trader might employ this approach, but when traders refer to buying the dip, they specifically are referring to buying the shares right after a price drop to capture specifically anticipated, generally near-term, gains.
What Is Buying the Dip?
As a strategy, buying the dip is often hard to distinguish from a trader’s general approach of buying low and selling high. Unlike someone who generally looks for low prices, traders who buy the dip as a strategy generally look for two specific 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
As a general approach, the trader will look for a sharp price decline and buy in quickly, hoping to capture the anticipated gains. While a trader can apply “buying the dip” to any asset, it is most often used in the stock market.
Examples of Buying the Dip
There are many situations where a trader might employ buying the dip as a strategy. To offer a few examples:
Often a stock will fall after a period of long term or otherwise sustained growth. For example, if a company’s stock has trended upward for the past several months, then takes a 10% loss in overnight trading.
In these cases traders may buy the dip based on the stock’s overall trend lines. They will see this as a short-term aberration in the price of a stock that has otherwise grown in long-term value. Expecting the trend to continue, traders will buy in.
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 the course of any given day the price will move up and down. When a stock dips, then, you can 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.
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 that other investors have begun to sell a stock they may jump on board, fearing 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 can cause a drop in the stock’s price as other traders, fearful that their rivals have just discovered a weakness in the company, dump their shares, too.
Another trader might assume that the mutual fund is simply restructuring its assets and will buy that dip, expecting prices to recover. Yet another one might react to an unexpected event in the news.
Say that a company is projected to have a strong quarter, yet nevertheless its stock dips. A fundamentals trader will look at the quality of the underlying business. Who manages it, for example, and what does its business plan look like? How solid are its debt-to-equity ratio and its cash flow management.
A trader who believes that falling prices don’t accurately reflect future sales may buy the dip. In this case they’re expecting that the stock price will bounce back as investors realize that the currently lower share price doesn’t reflect the actual strength of the company.
Risks of Buying 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. You might be right, but you are, however temporarily, betting against the market. This comes with the very real risk of getting this bet wrong.
Most trader mitigate their risk through techniques such as stop-loss orders. These allow a trader to set a minimum price. If the asset falls lower than that, they automatically cut their losses and sell it off. It means accepting a loss, but it’s better than watching your money enter a free fall.
The Bottom Line
Buying the dip, one of many approaches to investing, is when a trader or investor buys a security, usually a stock, that has just fallen in price on the belief that it will soon recover its value. It is a tactic employed for many reasons, but it has its risks. Situations where a trader might use this tactic are trend lines, fundamentals trading, random walk and emotional trading. Some critics dismiss buying the dip as a form of market timing.
Tips for Investing
- Should you buy the dip? Should you hold your position? Should you take more risks, or is it time to lie low? These are questions best considered with a financial advisor. Finding one doesn’t have to be hard. SmartAsset’s matching tool can help you find a financial advisor in your area, within minutes, to consider trading strategies, long-term plans and much more. If you’re ready, get started now.
- Traders who buy the dip will often depend on either fundamental or technical analysis. The former means that you have analyzed the underlying company’s operations and finances, while the latter is the process of studying stock prices and share trading history. Both of these two methods can be useful to investors.
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