• Last week, markets dropped sharply, but the S&P 500 has now rebounded
  • “Buying the dip” involves purchasing stocks after a price drop
  • But caution is needed; don’t rush into buying dips based on short-term movements

Last week’s trading began with a sharp drop that followed a rough few weeks which saw US$6.4 trillion wiped off global stock values.

The selloff was triggered by weaker US economic data, disappointing earnings from major tech companies, and a selloff in Asian stock markets, particularly Japan.

The chaos seems to have settled, at least for now, after the S&P 500 recovered by over 3% in the last two trading days.

But the sudden downturn has been a wake-up call for many investors.

Some experts suggest using this as an opportunity to make portfolio adjustments, while others see market dips as a chance to buy stocks at lower prices.

 

Why ‘buy the dip’?

A catchphrase among traders, “buying the dip” describes the strategy of purchasing a stock (or any asset) when its price drops.

Dips or pullbacks are a common part of the market, so the strategy can be effective for those who understand how to use it.

One reason investors or traders “buy the dip” is due to a concept called mean reversion.

Mean reversion reflects the idea that prices tend to fluctuate around an average value rather than moving in a straight line.

When the price drops below this average, traders might buy with the expectation that it will bounce back up to or above the average.

Essentially, the goal is to buy when prices are low and sell when they are high relative to this average value.

Buying the dip is also an effective way of decreasing the average cost of a position in a particular stock.

Kasim Zhafar at EQ Investors in the UK warns about the importance of maintaining perspective.

“Market fluctuations are an essential ingredient of investing. Share prices and the stock market can overreact in the short term,” he said.

 

When should you buy the dip?

A dip doesn’t have a set definition and can vary depending on the investor.

Short-term traders usually focus on small dips and quick gains, while long-term investors might wait for bigger drops and hold their investments for years to capture larger gains.

For a day trader, a dip might be a small drop of just 1%, while a long-term investor might only consider a 20% drop significant.

Essentially, “buying the dip” is more of an idea until you establish your own rules for what counts as a dip and how to trade it.

Some traders believe that a larger drop could mean greater potential for profit, but this isn’t always the case, as prices can continue to fall.

Managing risk is crucial when buying the dip, as is deciding when to take profits if the price starts to rise again.

“Use stop losses,” said advice from Ava Trade.

“When buying dips, it is essential to use hard stop losses to prevent amplifying losses if a bull market has reversed.

“For instance, if a stock falls from $50 to $40 and you decide to buy it, you can place a stop loss at $30 to cut your losses if the bear trend continues.”

 

When buying the dip can go wrong

Experts also recommend that investors hold off from rushing into buying the dip just because of a market drop.

History does show that a market rebound can follow a sharp decline, often leading to gains.

However, this doesn’t guarantee that the same strategy will work every time.

Investors might have seen the recent drop as a temporary overreaction, but there’s no certainty that it won’t lead to further declines.

It’s important to be cautious and consider the risks before jumping in and buying the dip.

“If there’s one thing to take from all of this, it’s that you should avoid basing investment decisions on big, single-day market moves,” said market expert, Reda Farran.

“Panic-selling during declines and buying back after rebounds is a surefire way to lose money.

“You’re generally much better off staying invested over the long run with a well-diversified portfolio that’s robust enough to handle different environments.

“And that means accepting the reality that the stock market moves down as well as up, and that it’s hard to time its movements,” said Farran.

 

One signal used for dip buying

One indicator that the market uses to suggest a buying opportunity during a dip is the Relative Strength Index (RSI).

RSI is a measure of the strength of a stock’s momentum, either in the upward or the downward direction, and is used to indicate whether a stock is oversold or undersold.

Generally speaking, an RSI above 70 means a stock is strongly bought; and an RSI below 30 indicates that it’s strongly sold.

An RSI above 80 meanwhile is extremely bought, and an RSI below 20 is extremely oversold.

Dip buyers can use the RSI to identify buying opportunities when it indicates that a stock is oversold.

 

Here are 20 ASX stocks with 9-day RSI below 30:


(data from Commsec)

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