'Buy the dip' means purchasing a promising stock when its price drops, assuming a fast rebound and future profits
- "Buy the dip" means buying an intrinsically sound or appreciating asset whose price has abruptly fallen.
- The big risk of buying the dip is that the drop isn't temporary, but becomes a long-range decline.
- While it involves market-timing, buying the dip also works for long-term investment strategies.
Buy low and sell high. It's a fundamental strategy of investing. Ah, but how do you know what "low" is - and when exactly to buy?
There's one time-honored technique that day-traders and seasoned investors use called "buy the dip." Buying the dip - also known as buying on the dip, or buying the dips - means purchasing an asset, usually a stock, when its price has dropped. The expectation is that the drop is a short-term anomaly, and the asset's price will soon go back up.
It's a chance to get a valuable asset at a cheaper price - like taking advantage of a two-day sale or special promotion to purchase something you've had your eye on. The catch is there are no advertised limited-time offers, in investing: You can't be certain if, or when, the asset will start to appreciate again.
Let's look more closely at the ins and outs of buying the dip.
What is buying the dip?
Traders and investors who "buy the dip" of an asset - usually shares of a stock - believe that its fundamentals are strong, making its appreciation most likely. So when a stock dips in price, which could be for a matter of minutes, hours, or days, they pick it up at a reduced cost - and then reap the gains when it re-assume s its march upwards.
The drop in price can be due to a variety of reasons. Maybe a lot of large, institutional stockholders dumped their shares. Maybe there was some news announcement that negatively impacted the company or its industry. Maybe the market overall is down.
The core point is that the stock is expected to rebound, and to increase in value, in either the short- or the long-term.
When to buy the dip
Unfortunately, there has never been a way to time the bottom of the market, or a particular share's drop. Dips don't come with a defined number or percentage. So there's no single, particular time to know when to buy the dip.
Fast fact: Professional day traders employ complex strategies and technical study patterns, such as breakouts, reversals, and candlestick charts, to analyze share price movements and decide to buy the dip.
There are, however, generally a few signs that suggest a dip worth acting on.
One occurs when a stock has gotten favorable research-analyst reports and buy recommendations, and based on them, its share price has been increasing for a period of time - what's technically known as an uptrend. But it suddenly reverses course. That could be a chance to buy it on the dip.
For example, say the stock of ABC Inc. was trading at $100. Over the past two months, based on its strong financials, it has steadily risen to reach $150, and analysts expect the price will hit $175. Then on one trading day the stock opens low, and declines further, down to $140 over the next few days. That is when an investor could "buy the dip" - confident it's just a blip: Nothing has fundamentally changed with ABC Inc., so its stock should recover and resume its upward course towards that anticipated $175.
Another strategy is known as the random walk theory. This refers to the fact that a stock's price fluctuates throughout the day. A stock's price may not necessarily constantly tick up throughout the day; prices can go up and down multiple times throughout the trading session. At the moment the price ticks down, an investor can buy that dip.
The random walk theory does not have to occur during an uptrend. It can occur at any time, as long as the stock is expected to rebound, and eventually appreciate in value.
Buying the dip and investment strategies
Buying on the dip is essentially a trader's market-timing technique, basing decisions on share price moves instead of underlying company fundamentals. Still, ordinary investors - even buy-and-hold types - can find it useful, working it into a long-term investing strategy. For example:
- Value investing: In value investing, investors pick stocks they believe are underpriced, trading below their company's intrinsic worth. In this situation, theoretically, an investor can buy the stock at any time. However, before purchasing the stock, they might wait for a dip in the price on a trading day, employing the random walk theory, or a week's-long decline, before buying the shares. So they'd get an undervalued stock at an even better bargain.
- Dollar-cost averaging: Buying on the dip can also be fit into a dollar-cost averaging approach, in which an investor buys the same amount of shares at set intervals - averaging out the volatility and the cost of the stock. Usually, dollar-cost averagers buy regardless of price increases or decreases, but here they'd continuously buy more shares whenever the price has dropped. Continuously buying on the dip is known as averaging down. For example, if an investor bought 10 shares at $40 and the price dropped to $30 and the investor then bought 10 more shares at $30, the average cost of the shares is $35. This strategy can help investors realize profits sooner because they don't have to wait for the price to go back above $40 to make a profit; now they just have to wait for it to go back above $35.
Stocks to buy on the dip
Buying the dip can encompass all stocks in every industry, and companies of any size or type. However, certain types of equities might offer more dip opportunities than others. Such as:
- Volatile industries, like technology, communications services, and commodities
- Growth stocks, whose companies are involved in new, innovative fields or research and development
- Cyclical stocks, which are sensitive to economic downturns, like those in the travel or hospitality fields
Risks to buying the dip
The primary risk of buying the dip, of course, is that the price will not increase again. Rather than the drop being a short-term dip, it's the start of a long-term downward trend.
If a stock price falls because of core problems with the company itself, such as a product failure, litigation issues, or an accounting scandal, then investors may be leery in purchasing the stock: These are serious operational issues that a company or its stock won't shrug off easily.
Financial reports are trickier. A bad earnings report for four consecutive quarters might well indicate serious performance issues for a company and a negative outlook. Conversely, one quarter's bad report would likely depress the stock - but that might be just a dip if it was due to a one-time event or write off.
This is why it's important to understand the fundamentals of a company's stock, rather than to just buy when its share price falls.
Quick tip: To reduce their risk when buying on the dip, investors can employ stop-loss orders. A stop-loss order sets a price at which a stock's automatically sold after a certain point. For example, if a stock is trading at $20 per share and drops to $15, an investor can purchase it at $15, hoping for a rebound. But they can also put in a stop-loss order at, say, $12. That will protect them against too severe a loss, should the stock continue to decline.
The financial takeaway
Buying on the dip refers to purchasing a stock (or any asset) at a moment when its price has taken a tumble - with the expectation that It's a temporary thing: the price will again increase, since the underlying outlook remains rosy, and the company will continue to grow.
It's an opportunity to buy an asset at a cheaper price- a tool to help you lock in the low that's central to the "buy low and sell high" mantra of investing.
A variety of investors can utilize this strategy, including long-term and value investors. No one knows how long a dip may last, so you have to be nimble.
The big risk of buying the dip is that the dip turns into a long-range decline. There are no guarantees: The price drop may never go back up again. But if it does, it's a great way to lock in an extra profit.