My stock is drifting down. Should I buy the dip?

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Is that price drop a discount or a danger?

© aneduard/stock.adobe.com; Photo illustration Encyclopædia Britannica, Inc.

You may have heard the phrase “Buy the dip,” whether from market experts interviewed on a financial TV channel or trading enthusiasts on social media. The idea is that you might buy an asset that’s falling in price. The problem with this suggestion is that it goes against another popular maxim: “Don’t catch a falling knife.”

Yes, that’s confusing. How can you possibly buy the dip without catching a falling knife? Is there a way to measure or time the “dip” to reduce the likelihood of getting hurt?

There’s some good news and bad news. The bad news is that you can never be 100% certain. The good news is that there are ways to reduce your risk so that your potential upside may be greater than your downside.

When talking about stocks, commodities, exchange-traded funds (ETFs), or any financial asset, a “dip” is a drop in price. Maybe a stock that was trading for $100 per share, for example, is now at $95 or even lower. That’s the dip. It’s really that simple. It’s also quite tricky.

When people say “buy the dip,” they’re assuming that the asset is going to bounce back. The dip is supposed to be a temporary decline in price. It’s as if the asset were taking a breather before sweating out the next leg of an upward climb (see figure 1).

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Figure 1: DIPPING SPOON OR CUTTING KNIFE? Sometimes you see a quick bounce in price after a stock dips. Other times what looks like a dip precedes a larger drop.

Source: Barchart.com. Annotations by Encyclopædia Britannica, Inc. For educational purposes only.

But if the asset’s longer-term uptrend has turned bearish, then the fall in price is no longer a dip. It’s a falling knife that may cut through your buying price if you jump in to grab it too soon.

What makes this tricky is that there’s really no way to tell the difference between what may turn out to be a “dip” or a “knife.” That’s why sound money management and a well-placed stop-loss order are critical when attempting this maneuver. It also helps to map out your strategy on a price chart so you can see where to buy and, if necessary, where to exit the trade.

It goes without saying that a stock that’s crashing due to internal mismanagement, exceedingly high debt, an inability to generate revenue, and unpromising prospects may not be the smartest dip to buy. In contrast, a falling stock whose company financials are reasonably sound makes for a better case of a bargain buy.

But when might be the right time to “pull the trigger,” so to speak? Tomorrow, the next day, or next week?

The answer to the “when” is the “where.” In other words, asking “Where’s the best place to plot a purchase?” is probably the better question. And to answer that question, it’s best to rely on a little technical analysis. In short, we need something of a tactical map.

If a stock that’s been trending up suddenly reverses—assuming the company is financially healthy—nobody can predict how far down it will go before bouncing back up (assuming that it does). There may also be unfavorable developments that you’re unaware of or that haven’t yet been publicly revealed.

Even if you can’t predict where prices might bounce, let alone resume climbing, you can anticipate price levels that other traders may be watching for a bounce. You can also identify price levels at which to exit your position should your buy point fail.

There are many ways to do this. For now, we’ll focus on just two simple techniques.

Take a look at figure 2.

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Figure 2: HOLD THE LINE. In 2020, the S&P 500 Index (SPX) bounced off the same price support level several times before resuming an uptrend.

Source: Barchart.com. Annotations by Encyclopædia Britannica, Inc. For educational purposes only.

The S&P 500 saw a volatile series of back-and-forth movements from August to November before resuming its uptrend to close out the year with a gain. Let’s take a closer look to decipher what traders were doing:

But what if you don’t see any historical support levels to fall back on?

What if the dip takes place along an uptrend? One popular indicator is the 50-day moving average.

A 50-day moving average plots the average of prices over the last 50 trading days. If the average is rising, it indicates an uptrend. If the average price is falling, then it indicates a downtrend.

Because the 50-day moving average has roughly a two-month lookback period, it’s considered a longer-term indicator. So, if the average is trending up, traders will generally assume that the longer-term trend might also be moving toward the upside.

As you can see in figure 3, traders sometimes use the 50-day moving average as a buy point. You can also see that this setup isn’t perfect. Because moving averages are lagging (and not predictive) indicators, prices can rise or fall rapidly, and it might take up to 50 days for the average to catch up, so to speak.

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Figure 3: VARIABLE SUPPORT. In this example, the 50-day moving average proved to be a strong support point throughout the uptrend.

Source: Barchart.com. Annotations by Encyclopædia Britannica, Inc. For educational purposes only.

These are just a couple of the many ways to buy falling assets. The strategies just discussed are pretty basic, but they’re simple enough to help you get started.

Here’s the big caveat: A dip can turn into a falling knife. In other words, the price of a stock can keep falling, and falling, and falling, until whatever’s left of an uptrend becomes history.

If you’re holding on to a position, this might present you with an uncomfortable situation. That’s why it’s important to prepare for such a scenario before it happens:

Buying the dip is essentially timing the market. Market timing can be extremely difficult to pull off. More often than not, the purchase of a falling asset requires strong technical analysis skills to identify and execute. With that said, understanding both fundamental and technical analysis can help stack the odds in your favor when attempting such a delicate maneuver.