Is Buying the Dip a Good Trading Plan?

Has the market found a bottom? Should you buy the dip? If you have read some articles lately or looked around on forums, you have most likely encountered the term ‘buying the dip’. Some traders believe that this simple trading strategy – which refers to buying a financial asset immediately after a price drop – is a treasure for stock traders if used correctly.

But is it a good trading strategy for all types of traders? Should you buy the dip when the markets are falling? And what is the most important rule you must follow to utilize this trading technique?

What Does Buy the Dip Actually Mean?

In simple terms, buy the dip refers to a trading technique when a trader purchases an asset after its price has dropped. Traders who use this strategy believe that the stock’s price drop is temporary and that the dip is essentially an opportunity for them to buy shares at lower prices.

Furthermore, traders who utilize this trading strategy in the stock market typically believe that stocks are generally more likely to rise in the future, and every dip is an opportunity to enter a long bull market. 

To many traders, buying the dips is the ultimate way to apply the Wyckoff accumulation pattern. This chart pattern refers to a trading strategy in which investors accumulate shares of a particular asset after the distribution (selling) phase. Note that in many cases, those who buy the dip already own shares of a specific company whose stock price has dropped from recent highs. After the drop, they see the new ‘cheap’ price as an opportunity to average down the stock price. 

Still, you should note that there is a big difference between buying the dip and dollar cost averaging investment strategies, and many even claim that DCA is the preferred option to manage a successful equity portfolio. 

Is Buying the Dip a Good Trading Strategy?

Like any other trading strategy, the effectiveness of buying the dip strategy depends on the type of trading style and the time frames you are aiming to hold your positions. Short-term traders typically use this strategy to capture small price movements after a significant drop.

In the trading jargon, they are looking for a market correction during a trend. Does it work? Yes, it works for some people; however, it is an extremely risky trading strategy and one that is hard to master. This method is also known as catching a falling knife, which… explains everything! Again, it’s a risky trading technique.

On the other hand, buying the dip is an entirely different trading strategy for long-term investors. These investors believe that the stock market tends to rise over time; therefore, every dip is an opportunity to accumulate stocks at discount prices.

For instance, the S&P 500, which is widely used as the benchmark index for the total market, tends to rise over the long term. So, if you trade the S&P 500 index with a long-term focus, you are likely to be able to turn the buying the dip technique into a profitable long-term trading strategy. 

Generally, buying the dip is more suitable for long-term investors who aim to buy and hold assets in their investment accounts. As such, choosing the right brokerage service could be vital so you can avoid paying high fees when holding companies’ shares for a long period.

Also, choosing the right asset and market is critical to use this trading strategy effectively. If you play the buy the dip strategy on assets like stock index funds, defensive stocks, bitcoin, or some FX currency pairs like the USD/JPY, you can certainly take advantage of this trading technique.

Should You Buy the Dip During a Falling Market?

Here’s the thing, you can never know when the market has reached its bottom. In essence, buying the dips means you assume the markets have reached a bottom, and from that point, they are likely to rise. In that case, when stock markets enter bear territory, you immediately think that prices are cheaper, and you potentially have an excellent opportunity to enter a long buying position.

It could work, but you must pay attention to the market conditions. For instance, buying the dip when the Covid-19 pandemic emerged in early 2020 was a smart decision. Back then, investors panically reacted to the pandemic, and stock markets worldwide crashed, but just a few weeks later, the stock markets bounced back and continued to break all-time high prices. Why? Because interest rates worldwide were at historically low levels, and investors immediately factored it in.

But the situation is entirely different when we analyze the stock market downturn in 2022. Since the beginning of the year, investors have been trying to determine if the stock markets have reached a bottom. Right now, there are too many risks – rising interest rates, inflationary pressure, the Russian-Ukrainian conflict, etc. Now, that does not mean that buying the dip was not a good trading strategy since the beginning of the year. Many short-term traders who bought the dips during the last year could make nice returns. 

A quick look at the S&P 500 chart will show you that buying the dip can work as the market bounces back every time after a significant price drop (many believe that it is a result of automated machines).

Yet, as we mentioned, there are many risks right now to buy the dip and hold your positions. You can quickly get underwater and stay in a losing position for several months or years. Instead, as an investment advice – when the market is flooded with so many risks, it’s better to wait for a while until the noise dies down and the market sentiment turns positive again. 

Final Thoughts – Should You Buy the Dip?

Buying the dip is a simple-to-use trading strategy that can work perfectly as a long-term investment rather than a short-term trading technique, especially in the stock market, where prices of major stocks and indices tend to increase in value over the long term.

Surely, some investors will tell you that buying the dip is a winning short-term trading strategy as well. As long as the asset is on a bullish run, you can take advantage of it and buy the asset every time the price drops. It all comes down to the cyclical nature of the stock market. 

After all, too many players in the equity market want stock prices to rise – central banks and politicians, investment banks and hedge funds, pension funds, etc. Those who buy the dips take this factor into account with the expectation that the stock market will rise in the future. They ignore short-term price movements, market volatility, and minor price corrections in stock prices and analyze the market with a long-term outlook. 

Nonetheless, despite the merits of this trading technique, experts will tell you that any attempt to time the market is a risky approach. One mistake can be fatal. Therefore, if you plan to apply this trading strategy, you must use risk management tools and know that you have the ability to cut losses, which is the most complex and painful aspect of trading. In addition, using technical indicators and chart patterns could increase the chances of not getting caught in a bear market territory.