If you’ve spent any amount of time investing or researching investments, you’ve likely come across the phrase “buy the dip.” It’s the practice of purchasing shares of a security after a price pullback from recent high levels. The idea is that any price below the high is a “discount,” and that in time, the price will rise again. It’s a simple concept that goes hand-in-hand with many investing strategies.
Whether you’re a “buy low, sell high” trader or a long-term investor with a dollar-cost averaging strategy, it makes sense to buy securities when there’s a pullback in the price. If you’re long on that company, it’s reasonable to assume that today’s highs are tomorrow’s lows, and that anything lower is a bargain.
Lots of people throw around the term “buy in the dip,” but don’t actually practice it. Here’s a closer look at what it means to buy in the dip and how this practice folds into long-term return on investment for patient investors.
An Example of Buying in the Dip
What does it mean to buy in the dip? Every investor defines “dip” differently depending on the stock and their outlook for its performance. Here’s an example:
ABC Company trades for $50. Nichole likes the stock, but her analysis shows that it’s overvalued at that price point, and that a better entry point is actually $45. A month goes by and the price of the stock drops to $45, prompting Nicole to buy shares. She plans to hold these shares for two years, as the company enters a growth stage. A month after she buys, the price rises back to $50. By the end of the year, the stock has reached $65: a $20 per-share appreciation for Nicole.
In the example above, the “dip” was a 10% pullback in price, which is a steep discount. For some, a 2-3% price pullback is enough of a dip for them to buy more shares. Most investors wait until the price recedes 5% or more from recent highs to jump back in with new shares.
Dip-Buying Investment Strategies
Most investing strategies encourage investors to buy in the dips. Here’s a quick look at why buying in the dip is so important, regardless of strategy:
- Dollar cost averaging. Buying in the dip allows investors to accumulate more shares of a company at a lower average price point. While that average will rise as long as the stock price does, it’ll remain lower than someone who buys sporadically and infrequently.
- Day and swing traders. The basic premise of trading is to buy low and sell high. To do this, traders need to capitalize on price fluctuations, which means buying in the dips. While their dips might only be a few pennies or a fraction of a percent, they’re still dips.
- Balanced portfolio. Investors seeking to manage a balanced portfolio will buy in the dips as a way to capitalize on the best price available within their portfolio. Stock A might be at an all-time high today, while Stock B is down, offering a dip-buying opportunity.
How to Buy the Dip
There are plenty of ways to buy the dip. The easiest is simply to wait for the price of a stock to fall X% and have money on the sidelines waiting to snap up shares. Many investors will even evaluate the stock through a fundamental lens to set price targets for buying in the dip.
Another way to buy the dip is via “good till canceled” (GTC) buy limit orders. These orders carry over across trading periods and allow an investor to set a strike price for purchasing a stock. For instance, you might set a GTC buy limit order for 50 shares at $40, for a stock that currently trades at $42. If the stock experiences a 4.75% pullback, it’ll trigger the order to buy in the dip.
Some investors will use technical analysis to spot patterns that lead to a price pullback. By identifying support and resistance levels, and looking for breakout signals, they’re able to hypothesize where a dip will manifest and jump in at a predetermined price point. There’s no wrong answer, so long as you’re not buying the stock at its recent high.
What Caused the Dip?
One of the most important factors to consider is the cause behind the dip. Why did the price pull back? There are several reasons to consider, and the reason factors into whether it’s a good idea to buy now or wait and see what happens.
One of the most common reasons for a dip is due to the theory of price waves. Generally speaking, this is the ebb and flow of the market based on investor sentiment. Bulls and bears constantly fight to control the price of a stock, and that price rises and falls based on which side has more momentum. A bearish dip in an otherwise healthy stock is a great opportunity to buy.
Other catalysts for a dip demand more scrutiny. For instance, if a company’s much-anticipated new product falls flat and there’s no clear plan to fix it, the long-term outlook for that stock might be riskier. The dip might actually be the start of a downtrend, which leads to significant losses for those who mistake it for a buying opportunity.
Always consider the cause of the dip before investing. Is it temporary or lasting? Trivial or major? Even if you’re long on the company, it’s critical to understand the reason behind a pullback.
Look for Dips as an Opportunity
Investors are always looking for the next big opportunity. Most of the time, it’s right in front of them. Learn to buy the dip and you’ll benefit from the price appreciation that’s likely to follow. A small price decline presents a big opportunity for savvy investors. And while time in the market is often better than timing the market, there’s nothing wrong with capitalizing on a pullback.