Buying or adding to an existing long position of an asset during a period of downward price pressure, hopefully with the opportunity for the price to recover
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Buying the dip is a strategy used by investors and traders that involves buying or adding to an existing long position of an asset during a period of downward price pressure, hopefully with the opportunity for the price to recover. This strategy is commonly seen for assets that are fundamentally sound but have been sold off due to larger market sentiment or overreaction.
Investors “buy the dip” and increase their exposure to that asset when prices are depressed in anticipation of prices recovering and earning larger returns. Disciplined and prudent investors base their decision on when to buy the dip on careful research and analysis as the downside risk for buying the dip is quite high as the investor is increasing their overall position on that particular asset.
Buying the dip is a term used to describe an investment strategy of buying a fundamentally sound asset when its price falls, commonly due to outside factors.
Investors then “buy the dip” in anticipation of prices recovering for that asset.
As buying the dip increases an investor’s position, the returns can be higher if prices increase, but the risk of a potential loss can also be greater if prices fall.
When is Buying the Dip Successful?
Buying the dip can be advantageous when the long-term price trend of a security is positive, as the average cost of building a position decreases when there is a dip. However, it can be disadvantageous in a similar vein when the price declines persist for an extended period of time and the position has increased in size, raising the potential loss.
Using stocks as an example, the stock market has been known to overreact to news flow at certain periods, especially when there is high uncertainty. A prime example was in February and March 2020 at the onset of the COVID-19 pandemic, where economic shutdowns caused prices within the stock market to draw down significantly. The S&P 500 Index, which is a popular index that tracks the stock performance of 500 large U.S companies, saw a ~31% decline in price before hitting bottom and rallying subsequently.
While it is possible to experience a rebound after a significant price decrease, it is also just as likely for the asset price to continue declining. In the example above, the stock market negatively reacted to the uncertainty of the COVID-19 pandemic. However, fiscal and monetary stimulus, in addition to increased data and research on the virus itself, alleviated concerns in the stock market quickly.
Without the economic stimulus, or if the virus was more lethal than anticipated, the stock market might not have rebounded as quickly. There are many cases where a particular security does not recover and continues to drop, leading to increased losses. Therefore, investors and traders should be wary of such situations when considering to “buy the dip.”
Benefits of Buying the Dip – Cost Minimization
As mentioned above, buying the dip is an effective way of decreasing the average cost of a position in a particular security. It can amplify potential returns if the price ends up increasing.
An investment management firm is considering investing in ABC Company.
ABC Company’s common stock is currently trading at $10/share, and the investment management firm believes its intrinsic value is $20/share.
With this, the firm goes long 100,000 shares, building a position of $1,000,000 in ABC Company common stock. If its thesis is correct and the stock increases to $20/share, the position would have increased to $2,000,000. It represents a 100% return.
Now, consider an exogenous event that causes the price of the stock of ABC Company to decline to $5/share. However, the investment management firm still believes it should be worth $20/share as none of the fundamentals for ABC Company, its industry, nor the competitive landscape has changed.
The firm can “buy the dip” and increase its position. It proceeds to go long another 100,000 shares, now with a position of $1,500,000 (initial $1,000,000 position + new $500,000 position).
However, the average cost of the shares is now only $7.50/share vs. $10/share previously. Now, if the firm’s thesis is correct and the stock increases to $20/share, the position would have increased to $4,000,000. It represents a 167% return.
From this example, it is clear that buying the dip can increase the potential return, given that the original investment thesis and company fundamentals of ABC Company remain intact.
Shortcomings of Buying the Dip
While buying the dip can potentially minimize the cost of a position and increase potential returns, it can also result in a scenario where losses are magnified. At times, market participants may overreact when selling a security; however, they also can be justified in their rationale for selling.
Generally, when a security price declines, there is a valid reason why the price is decreasing. For a stock, it can be the result of lower-than-expected earnings, increased uncertainty, or a variety of other reasons. As an investor or trader, it is important to be cautious of buying the dip and have a strong rationale for why the security is mispriced.
Buying the dip is used by many investors and traders based on a preconceived notion that the price should revert to previous levels. However, it is not always the case. There are many examples of companies that have gone bankrupt, which results in stock prices of these companies going to $0/share.
Continuing from the example above, where the investment management firm increases its position from $1,000,000 to $1,500,000 after a price decrease of ABC Company from $10/share to $5/share.
If its thesis turns out to be incorrect, and ABC Company goes to $0, the firm loses $1,500,000, losing more capital than they initially would have lost before buying the dip.
Thank you for reading CFI’s guide to Buying the Dip. To learn more about investing and trading, the additional CFI resources below will be useful:
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