What does ‘buy the dip’ mean?

Dip buying refers to the strategy of buying an asset after it has dropped in value. It follows along the same lines as the age-old mantra of “buy low and sell high”.

While the strategy seems straightforward enough, there is more to it than simply looking for the fastest dropping stocks and sinking your money in. You also need to see strong indications that the stock will rise in value again. Obviously, there is no benefit to the buy the dip strategy if the stock continues in free fall and your investment shrinks.

So what is a buy the dip strategy and how can you use it? One simplified version is to look for strong companies whose stock price has declined for reasons not unique to that particular company or industry but due to overall market conditions. A recent example would be the coronavirus pandemic.

When the extent of the disruption the virus would cause the global economy became clear, many otherwise well-positioned companies' stock prices plummeted as investors moved their money to traditional safe havens such as the US dollar.

The S&P 500 index, which tracks the performance of the top 500 US companies and is considered the benchmark index of the US stockmarket, plunged to the low of 2,447 in March 2021.

While it can be difficult to know how long a particular stock will remain low and where the bottom will be, the assumption is that a company with strong fundamentals will eventually rebound.

We know now that many of these companies rebounded quite quickly, with many hitting new highs in the midst of the disruption. By the end of August 2021, the S&P 500 had doubled from its pandemic low and continued moving up to new highs.

Dip buying perspectives

One drawback of dip buying in trading is that it inherently requires having idle cash available and not already invested when the dip happens. The cost of waiting for the dip in terms of lost opportunity can be higher than simply investing in strong companies and riding out any temporary downturns.

These opportunity costs are particularly relevant for position traders who look for long-term value stocks, and less so for day traders who are constantly buying the dip and exiting their position after they have made a profit.

Day traders seek to identify temporary pullbacks, or dips, which are a normal phenomenon in stocks that are experiencing an overall general uptrend, while position traders might look for the bottom of a downtrend on stocks that have strong overall fundamentals and should recover.

An alternative way of buying the dip is to increase a previous position when the price decreases, thus reducing the average price per share and increasing the profit margin on the overall position after the stock recovers. This strategy can be considered part of the definition of buy the dip and is referred to as averaging down.

However, it can be a dangerous strategy, since if the stock continues to fall you are increasing your potential losses.