The expression “time is money” is true in most senses, but nowhere more so than in the stock market.
The amount of money you make or lose when you actively trade often depends on your market-timing skills. If you time things right, you’ll buy low and sell high, making a profit. If you time your investments wrong, you’ll buy high and be forced to sell low, reaping losses.
So, when is the best time to buy? Often, the answer is when a dip takes place.
What Does “Buy the Dip” Mean?
The equities market is a self-balancing system based on the law of supply and demand. When there are more buyers who want a stock than sellers who want to sell it, its price increases, enticing more sellers to get involved. On the other hand, when there are more sellers than buyers, the price of the stock must fall to get buyers excited.
In the market, you see quite a few peaks and valleys as the supply and demand equation works to find fair values of equities.
A dip means that the price of a stock is down, but likely for a short period of time. Buying the dip is a short-term trading strategy that gives day traders the ability to exploit these short-term price drops for a profit.
Essentially, traders buy stocks at lower prices when dips take place in hopes of turning around and selling their shares shortly after the purchase, when the price of the stock normalizes back to higher levels. The difference between the purchase price and the later sale price becomes the profit (or loss) for the trader.
Why Are Dips Seen as Buying Opportunities?
“Buy low, sell high.” The expression is the basic premise of investing — the idea that when you buy a stock, your goal is to buy in at a low price and sell when the price increases to make a profit.
Dip buying is a faster-paced version of doing just that. Many dips usually only last for a portion of a trading session — sometimes only a few minutes — making them perfect opportunities for quick profits from day trading.
When a dip happens, investors who buy in enjoy a discount to the general price the stock should be trading for. It’s like finding a coupon for a product you wanted to buy anyway. And while coupons limit the amount of the product you can buy using the offer, when you find a discounted stock, you can buy as many shares as you’d like and enjoy the discount.
Pros & Cons of Buying the Dip
At first glance, buying the dip seems like a great way to go for any investor, but you should never judge a book by its cover. As with any other investment strategy, there are potential upsides and potential downsides to consider. Here are some of the most significant pros and cons to think about before diving into dips in the market.
Pros of Buying the Dip
Buying the dip has become a popular idea for several good reasons. Some of the most exciting benefits to taking part in the strategy include:
1. High Potential Profitability
Long-term investors don’t tend to worry about peaks and valleys in the market. Instead, they buy equities they intend to hold for a while, no matter the short-term ebbs and flows seen in its price.
However, technical analysis pros who have the ability to time dips in the market have the potential to beat the returns of long-term investors by wide margins. After all, if you can get in at a discount, you stand to make compelling gains when the uptrend in the value of the stock commences.
2. Dips Happen All the Time
Dips happen regardless of whether Wall Street is in the midst of a bull market or bear market. While the market is seen as a balanced system, it’s actually a constant battle between the bulls and the bears that’s always using supply and demand to work out inefficiencies.
As a result, short-lived peaks and valleys are far more common than most newcomers to the investing community think. That means there are always opportunities somewhere.
There’s a bit of excitement that comes along with a discount. After all, you work hard for your money, and if you can spend less than you expected, the transaction is going to make you feel good. The same is true whether you’re buying a new pair of jeans or shares of Apple stock.
Cons of Buying the Dip
At this point, you’re probably pretty excited about trying your hand at dip buying, but don’t let the allure of big profits fool you — it’s not all sunshine and rainbows. Before you decide to take part in the strategy, consider the following pitfalls:
The market is filled with volatile price movements, and even pros at technical analysis get it wrong from time to time. Attempting to make a quick profit in just about any space can end in a headache, and the market is no different.
Finding the right time to jump into a stock that’s experiencing volatility is a challenge for even the most experienced traders. Beginners hoping to score a quick profit just because a stock’s price is down could be in for a bumpy ride.
2. History Isn’t Always an Indicator of the Future
It’s a widespread saying that history repeats itself, but it’s not always true, especially when you’re talking about the market.
The idea of buying the dip is based on the premise that a stock’s past performance is indicative of what you can expect in the future, but that’s not always the case either.
Unfortunately, this false premise is why even the best of the best traders often make losing trades. When a dip appears, you may think it’s a good time to buy, but there’s no telling when or if the dip will correct itself. Sometimes a stock’s price goes down and stays down — or goes even lower.
3. There Could Be a Reason for the Dip
Unwarranted declines are commonplace in the market, but that doesn’t mean every dip you see is unwarranted. Sometimes, there are serious underlying issues in the business represented by the stock that causes investors to abandon ship, leading to a dip on the chart.
Unfortunately, with buying the dip being such a fast-paced process, traders don’t always have the time to do adequate fundamental research before executing their trades. Instead, they may dive in on stocks that have fallen due to issues that aren’t likely to resolve themselves in the near term, leading to losses.
Who Should Buy the Dip?
Buying dips in the market may seem like an exciting way to turn a profit, but most investors shouldn’t be chasing fast-paced gains in the market. For the right trader, though, buying the dip can be a good trading strategy. You may be a prime candidate for buying dips if:
1. You Are Risk-Tolerant
As mentioned above, there are significant risks that come with attempting to make meaningful profits in the market over a short period of time. The prime candidate for the strategy would be someone who isn’t afraid to lose a few bucks here and there in search of the treasure trove.
2. You’re Skilled in Technical Analysis
Technical analysis is the process of analyzing trends in a stock chart to determine where the value of a stock is likely headed. Swing traders use indicators like support and resistance to create a theoretical range in which the value of the stock should stay, and they take advantage of various other indicators to tell them where in this range the stock is and the direction it’s likely headed next.
The best candidate for this strategy is one who has a deep understanding of technical analysis and is able to use it to make fast-paced decisions in the market.
3. You Don’t Care About Income From Investing
Because buying the dip is a fast-paced process, investors and traders who take advantage of the strategy will rarely hold a stock long enough to collect dividends. If you’re a long-term investor who depends on income from your investments, this strategy simply won’t fit the bill.
Take Part in Dollar-Cost Averaging When Buying a Dip
When using the buy-the-dip investment strategy, one of the best ways to protect yourself from significant losses is to employ dollar-cost averaging.
The reality is that when you buy a dip, you’re buying a stock that’s trending downward, and there’s no 100% accurate way to tell where the bottom is. As a result, if you’re making a large purchase into a dip, it’s best to spread your purchase over time by making multiple smaller purchases.
For example, say you notice a stock is on a downtrend and you believe the trend will last no more than a couple of trading sessions. Instead of buying 100 shares of the stock right now, you might decide that you’ll buy five blocks of 20 shares, with each purchase taking place an hour apart.
In doing so, if the price of the stock continues to fall after the first purchase, the later purchases at lower prices bring the average price you pay for all the shares down, increasing your overall earnings potential when the dip subsides and the stock makes its way back up.
Can Long-Term Investors Benefit From Buying the Dip?
While most dips in the market tend to be incredibly short term, making them best for traders rather than long-term investors, there are some instances when long-term focused investors can benefit from buying the dip and using dollar-cost averaging in the process.
One of the best recent examples of this was during the coronavirus pandemic. When the pandemic set in, the overall market experienced painful declines as the global economy took a major hit. During this time, countless individual stocks quickly became undervalued.
The declines during the pandemic started in late February and found the bottom by late March. Even long-term investors who weren’t trading stocks daily had time to put extra money to work in the market. After the month-long market bloodbath, stocks began to recover. Investors with a long-term outlook who took the opportunity to buy new shares as prices were falling started to benefit greatly.
So, while the buy-the-dip concept is generally seen as a trading strategy, in some cases, it makes for a great investing strategy as well.
Buying the dip is an exciting concept. After all, who doesn’t want a discount on a product they’re purchasing, be it a toy for their kids or a share of stock?
However, the concept can also be dangerous. After all, when stocks fall, there are often reasons for the declines, and the dips seen in the stock chart could become long-term headaches.
Nonetheless, with a little research, you’ll be able to tell whether there’s a serious reason for the declines or if the dip is likely to be short lived. So, when taking advantage of the buy-the-dip strategy, as is the case when making any other investment decision, it’s important to do your research and get an understanding of what you’re buying before you make the purchase.