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Buying the Dip

Going long on a security during a period of downward price pressure, hopefully with the opportunity for the price to recover

What is Buying the Dip?

Buying the dip is a phrase/strategy used by investors and traders that involves going long on a security during a period of downward price pressure, hopefully with the opportunity for the price to recover. It is more common for securities and assets with daily price fluctuations, such as stocks, which have been seen to occasionally experience negative price movements while the underlying company fundamentals remain the same.

 

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, in a similar vein, it can be disadvantageous when price declines persist for a long period of time and the position has increased in size, therefore increasing 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, a popular index that tracks the stock performance of 500 large U.S. companies, experienced a ~31% decline in price before hitting bottom and rallying subsequently to that.

 

Buying the Dip

 

While it is possible to experience a rebound after a large 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.

 

Example

An investment management firm is considering investing in Stock ABC.

ABC is currently trading at $10/share, and the investment management firm believes its intrinsic value is $20/share.

The firm then goes long 100,000 shares, building a position of $1,000,000 in Stock ABC. If their thesis is correct, and the stock increases to $20/share, the position would have increased to $2,000,000. This represents a 100% return.

Now, consider an exogenous event that causes a large shareholder of Stock ABC to sell its position. This causes the price of Stock ABC to decline to $5/share. However, the investment management firm still believes it should be worth $20/share.

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 prior. Now, if the firm’s thesis is correct and the stock increases to $20/share, the position would have increased to $4,000,000. This 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 Stock ABC 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 as to why that price is decreasing. For a stock, it could 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, this 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.

 

Example

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 Stock ABC from $10/share to $5/share.

If their thesis turns out to be incorrect and Stock ABC goes to $0, the firm loses $1,500,000, losing more capital than they initially would have lost before buying the dip.

 

Additional Resources

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:

  • Dow Jones Industrial Average (DJIA)
  • Growth Stocks vs Value Stocks
  • Long and Short Positions
  • Six Essential Skills of Master Traders
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