Based on age old Wall Street theory – buy low, sell high – buy the dip covers the first part. In other words, following a significant drop in the price of a security or index, investors should increase positions to capitalize on what is expected to be an eventual upswing.
The market isn’t stagnant. It goes up and it goes down. Individual stocks increase and decrease in value. To make money on that fluctuation, investors need to buy when stocks are a bargain and sell when they are up in price.
The “catch” of course is that what goes downs doesn’t always have to go back up, either right away or in some cases, ever. If the fundamentals of a company change (for the worse) investors can lose lots of money. Buying the dips, it seems, only works when the market is oversold.
Timing The Reversal
It’s one thing to buy stock when prices are low, another to sell at the optimum time. This is a difficult feat because first, one must determine that the so-called dip is temporary and not a sign the company is about to go out of business. Investors also should evaluate whether the dip represents a buying opportunity because it shouldn’t have occurred in the first place.
If you think this is what has happened, it makes sense to buy the dip. If you are right, eventually the stock will reverse course and begin moving upward. Your next problem to solve is deciding when the stock has gained about all it will gain.
There are two main concepts in support of buying on the dip, reversion to the mean and market sentiment. Reversion to the mean tends to happen when the price is too high or too low. All things being equal, outliers like dips should revert to the middle of average price.
Market sentiment is built around the idea that prices are driven by emotion and fundamental value. This theory suggests that market sentiment pushes prices high or low before they revert to the mean. Whichever concept you follow, the action is the same: buy the dip, sell the rally.
As with all market theories, buy the dip has some built-in caution. What if the market never actually dips? This is especially an issue for traders (as opposed to long-term investors). Traders count on making short-term bets and need dips to feed momentum.
When volatility is low and intraday moves anemic, it’s very difficult to see the movement and take advantage of it. When daily moves are almost exclusively to the upside, there is literally no dip. Moreover, a lengthy stretch without a pullback doesn’t necessarily increase the likelihood one will happen.
Things To Watch For
In a “no dip” environment investors or traders can watch for 3 things that could drive prices down: (1) unexpected changes in policy by the Federal Reserve; (2) political risk due to lack of expected tax-reform legislation and (3) geopolitical tension. With the latter, areas to watch are obvious – North Korea and China.
Related: EQUITIES VS. FIXED INCOME
Risk Without A Dip
Given the generally upward move of equity indexes, talk of an eventual correction or dip becomes even more intense. This leads to discussion about the inherent risk of missing the correction, a fact that tends to panic investors.
Some experts suggest the systemic risks everyone seems to expect, just aren’t there right now. In this type of environment buying on the dip only works if you take a long view are ready to ride any resulting volatility.