What is Buy the Dip Strategy in Trading – Working and Example

‘Buy the dip’ is one of the most common phrases in the stock market. It is sort of a  go-to strategy for all investors and stockbrokers. The concept of buying the dip refers to investing or buying a stock if there is a dip in the stock market. In this blog, we have explained how buying the dip strategy works and ways to implement it.

What is Buy the Dip Strategy?

Buy the dip refers to buying a stock when its price goes down in the stock market. The underlying assumption of such an investment is that the stock price will go up soon. The strategy works on the principle of buying low and selling high to maximise the returns from the investment.

However, the strategy only works for stocks with solid fundamentals and those that are bound to rise with the market. 

How does Buying the Dip Strategy Work?

The buy-the-dip strategy predicts a future rise in the prices of a particular stock. If you have enough evidence and indications to believe that the stock price will increase in the future, you can earn good returns from the buy-the-dip strategy.

However, your buy-the-dip strategy might fail if the stock prices continue to fall and show a downward trend that might continue for a long time. Hence, the working of the buy-the-dip strategy depends on how well you can predict the market.

How to Use Buy the Dip Strategy?

When adopting the buying dip technique, there are various aspects you need to keep an eye on. It would help if you first located a financial asset experiencing a sharp increase in value. The second step is to determine when the trend changes and the asset begins to drop rapidly. Many things could be to blame for this reduction, including:

• A company might, for instance, announce a poor quarter, cut its dividend, announce the passing of a CEO, or even lose a patent.
• Additionally, if the central bank makes an unexpected decision, a currency pair may experience a significant decline.

Because the market frequently overreacts, the buy-on-dip strategy is ideal. Third, you need to know how far the decline will go. 

Why is Buying the Dip Beneficial for Investors?

 A dip in the stock market can be attributed to several reasons. However, the market’s current dip is caused by an unstable economy and increasing geopolitical tension among countries. Here is why buying the dip is a good strategy for investors:

1. Averaging of Rupee Cost

When you buy additional company stocks at a lower price than what you paid earlier, it gives you a window to reduce the stock’s average price. For instance, if you bought a stock at Rs.10,000 and it comes down to Rs. 9,500 or Rs. 9,700, the prices can be averaged.

2. Access to Strong Stocks at a Low Price

If the price of a fundamentally strong stock decreases for a while, it allows the investors to buy it at a low price. These stocks are priced quite high when the market is favourable and bullish. Hence, a dip in the share market makes expensive and solid stocks available for investors.

3. An Upward Trend

The market tends to rise or increase in the long run. The market has outperformed itself several times, delivering great returns to investors. Hence, the buy-the-dip strategy increases the return earning potential of the investors. 

Example of Buying the Dip

The chart enclosed below shows the movement of the S&P 500 index over the last 10 years. The red circles are used to depict the decline in prices of the index. Hence, it would have been an ideal scenario for investors to buy the stock when the market was down by 10%. However, it is difficult for investors to predict the movement of the S&P 500 index if they do not know the long-term trend. They only get a fair picture when there is a dip of 20%. Hence, the investor will have to bear the losses until the trend moves downwards.

Risk Management When Buying Dips

You must consider the relevant risks when you apply the buy-the-dip strategy. The primary risk of using the strategy is that the prices will keep falling and reach a low where you will have to register losses on the trade. There are a few ways to manage the risks associated with the dip stock. Let’s have a look at how you can manage different risks.

1. Use Stop Losses

If you are applying the buy-the-dip strategy to buy stocks, you must use stop losses to safeguard yourself from losing money beyond a point that might affect you financially. For instance, if a stock falls from Rs.500 to Rs.400, you buy it. However, if you put a stop loss at Rs.300, you will not lose money if the stock price goes below Rs.300.

2. Buy When the Uptrends are Confirmed

You must try to use the buy-the-dip strategy only if you are too sure that the market will see a rise in future. It would be best to look for highs in the price and lows to be assured that the price will rise soon.

3. Don’t Use it in Isolation

While buying the dip strategy is a great way to invest in stocks, you should never consider it in isolation. You should deploy other strategies and use them along with the buy-the-dip strategy to make an investment decision. When you use a mix of strategies, the risk of associating the stock with one optimal price reduces.

What are the Alternatives to Buying the Dip?

 While buying the dip is a strategy widely used in the world of investing, there are a few alternatives to buying the dip that will help you fix the loopholes of the dip strategy. Let’s look at some of these effective alternatives that can help you make a better investment decision.

1. Price Increase

You might buy a stock if there is a price increase. A price increase indicates a bull market and how people are interested in buying the stock, increasing prices.

2. Breakout to a New Price

You can watch out for a buying breakout by analysing different charts and patterns, like a cup and handle, before buying a particular stock.

Final Word

Buying the dip as a strategy should be carefully used. The strategy is based on the premise of future price movements. As predicting future price movements is difficult, you must look for other strategies that complement the buy-the-dip strategy for the best results.

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