Buy the Dip Trading Strategy: Rules, Backtest and Examples

Market crashes and recessions can be opportunities for long-term investors to buy assets at bargain prices. Market participants call the approach “buying the dip.” But what does it mean to buy the dip?

To buy the dip means to purchase an asset when its price has dropped so that the asset is bought at a bargain price. It is an investment approach that follows the basic principle of “buy low, sell high,” but in this case, the focus is on the buying aspect. The concept of buying the dip is based on the belief that the “dip” is only a short-term price decline and the asset, would likely bounce back and increase in value with time.

In this post, we take a look at the buy the dip strategy and how investors use it in various assets. At the end of the article, we make a backtested buy the dip trading strategy.

What does it mean to buy the dip?

To buy the dip means to purchase an asset when its price has dropped. It is an investment approach that follows the basic principle of “buy low, sell high,” but in this case, the focus is on the “buy” aspect.

The concept of buying the dip is based on the belief that the “dip” is only a short-term price decline and the asset, would likely bounce back and increase in value with time. The strategy is commonly seen for assets that have strong fundamentals but have been sold off due to larger market sentiment or overreaction.

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. Investors use the strategy to go long an asset after its price has experienced a short-term decline, such that, as the asset is cheaper, they get to buy more of the asset with any given amount of money. This allows them to increase their exposure to that asset in anticipation of prices recovering so that they earn larger returns. However, the risk and reward of dip-buying should be constantly evaluated.

The buy the dips strategy has been around for a long time but has been made more popular with the emergence of the crypto market and its unique volatility. It is similar to value investing which seeks to buy assets at discount prices. It is also similar to dollar cost averaging, as it can lower one’s average cost of owning a position.

While this approach can be profitable in long-term uptrends, it is very difficult to use it profitably during secular downtrends. The downside risk for buying the dip is quite high as the investor is increasing their overall position on that particular asset. Smart investors who use this strategy base their decision on when to buy the dip on careful research and analysis.

How “buy the dip” works

The price movement of any asset comes in waves of up and down, even when the asset is in an overall upward trend. This is what the buy the dip strategy capitalizes on — when an asset in an uptrend experiences a short-term dip, chances are high that it would recover and continue in the trend direction.

The strategy works on the basis of an asset having an upward trend over the long term, so any short-term decline becomes an opportunity to get the asset at a bargain price.

In practice, the buy the dip strategy involves having cash around when the market is making a dip since you would need that to open long positions.

So, holding a portion of your portfolio in cash or lower-risk liquid assets out of the market and waiting for the price of whichever asset you are interested in to fall is a necessary part of practicing this strategy. Once the price of whatever asset you’re tracking falls, you take all or some of the cash you’ve been holding and purchase more of the asset. Alternatively, you can develop a trading strategy based on the buy the dip principle, something we get back to in our backtest later in the article.

This way, you lower your overall average cost of buying the asset, which would enhance your returns if you hold the asset long enough for the price to recover over time and continue in its upward trajectory.

Essentially, there are two requisites for buying the dip: a significant decline in the asset’s price, and a strong indication that the asset would rise again.

For most markets, a 10% decline is considered a significant market correction. Those who trade based on technical analysis alone would consider the presence of an established trend before the decline as the main indication that the asset would rise after the decline. But those who trade based on fundamental analysis would focus on the asset’s fundamentals and macroeconomic factors — for example, when a large corporation’s stock price drops suddenly due to broad market fears, investors would be happy to buy the stock at the new cheaper price, knowing that the stock has strong fundamentals.

On the broad market level, the stock market tends to overreact to certain news that indicates high uncertainty in macroeconomic factors. For example, in February and March 2020 following the emergence of the COVID-19 pandemic, the stock market declined significantly due to economic shutdowns.

The S&P 500 Index, which tracks the stock performance of 500 large U.S companies, declined by over 31% before it reversed. Those who bought on that dip would have enjoyed the subsequent rally that ensured.

The market recovered very fast due to the fiscal and monetary stimulus initiated by the government, in addition to increased data and research on the virus itself, which alleviated concerns about the pandemic. If the government didn’t come up with the economic stimulus, or if the virus was more lethal than anticipated, the stock market might not have rebounded as quickly.

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. There are many cases where a particular security does not recover and continues to drop, leading to increased losses. But this is more likely to happen with individual stocks than with a broad market ETF that tracks an index like the S&P 500. So, be careful when practicing “buy the dip” on individual stocks.

Is buy the dip a good idea? Is it bullish?

The buy the dip strategy is just purchasing an asset (a stock or an index) after it’s fallen in value. It is a bullish approach to those who practice it, as they use it to find buying opportunities in the market. That is, when an asset price dips, it may present an opportunity to buy it at a discount which enhances future gains if and when the asset rebounds to its previous high.

Buying the dip is a long-term investing strategy that requires a great deal of market research and planning. To use this strategy, you have to analyze the asset to be sure that it is in an uptrend and also have an idea of the normal “dip size” that represents a market correction.

Without knowing, in advance, the price drop that would cause you to buy the asset, it’s difficult to apply the buy the dip strategy. Generally, the larger the dip, the more you stand to gain when the asset price returns to its previous levels. A 10-20% dip is normally acceptable. When the dip is too much, it may indicate a shift in the underlying trend of the asset, and it may never return to its high in a long time.

Another thing to consider when using the buy the dip strategy is the cash you would use to buy the asset when it dips. To use the strategy, you must hold some cash in your portfolio, waiting for such opportunities to arrive. Even when you have done good market research and know the size of dip to buy at, you need cash to take advantage of the dip.

Buying the dip can be advantageous when the long-term price trend of a security is positive; in this case, the average cost of building a position decreases when there is a dip.

However, it can be disadvantageous when the price declines persist for an extended period of time due to fundamental or macroeconomic factors. For example, in early 2022, most markets fell amid concerns about the ongoing pandemic, inflation, Russia’s invasion of Ukraine, and interest rate increases. Those are legit macroeconomic factors and there are concerns about a prolonged recession.

As of the time of writing, no one knows when the bottom hits, so trying to time the market may not be a good idea. As a result, investors simply track the market and wait to see what happens. However, smart buy-and-hold investors, may consider it an opportunity to buy index ETFs cheaper and hold for a long time, knowing that whatever happens, such assets would recover with the entire market and trend higher.

Buy the dip crypto?

As with any other market, in the cryptocurrency market, the buy the dip strategy is also used. Crypto coin investors see the dip as an opportunity to invest in a crypto token with the hope to profit from a potential future price increase. While this strategy may work, as in the stock market, there is a need to be cautious as the crypto market has a short history compared to stocks.

The crypto market came up only 13 years ago, and most cryptocurrency investors became familiar with the buy the dip approach after the downtrend of the cryptocurrency market in 2018, during which they learned how risky and speculative the crypto market really is. Buying a coin or token in a downtrend does not necessarily mean that its price is guaranteed to increase — the “dip” can always get “dipper”, making it difficult to know the right dip size to enter the market.

The cryptocurrency market has been in a downtrend since peaking at nearly $3 trillion in November 2021, as the entire industry’s value is below $1 trillion as of August 2022. Many crypto assets lost up to 70% of their value, and Bitcoin (BTC), the world’s most valuable crypto asset, hasn’t fared well, either — it has shed 55% of its value in 2022 as of August. Even at that, no one knows whether it would continue to fall “dipper”, as inflation and recessionary fears are still consuming investors’ minds, pushing them away from riskier assets like cryptos.

Nonetheless, some may consider the low prices a good opportunity to invest in cryptos, web 3, and the metaverse. If you want to follow this approach, you must have strong emotional intelligence and understand the turbulent nature of the market.

Buy the dip, sell the rip – mean reversion

“Buy the dip, sell the rip” is a popular slogan in the crypto market. It is another way of saying “buy low, sell high” which is the popular version in the stock market. But whichever name it is given, it works on the principle of mean reversion, which implies that the price oscillates about its mean. When the price moves significantly above or below its mean, it becomes overvalued or undervalued, creating a trading opportunity.

• Pros and cons of mean reversion strategies

That is, when the price experiences a big “dip”, it has moved significantly below its mean, which means that it is likely undervalued and trading at discount. This presents a buying opportunity — buy the dip. On the opposite side, when the price moves significantly above its mean, it becomes overvalued, which is the “rip”, so you should sell.

The best “buy the dip” indicators

There are many indicators you can use to trade the buy the dip strategy. These include oscillators and momentum indicators, which can be used to ascertain oversold and overbought conditions in the market, as well as the show moving averages that show the price mean. There are also the Bollinger Bands that show both the mean and the oversold/overbought conditions. Here are the common indicators for trading the buy the dip strategy:

• Relative strength index (RSI)
• The Stochastic indicator
• Williams R%
• Internal bar Strength (IBS)
• Bollinger Bands
• Moving average strategies

Buy the dip strategy (backtest)

Let’s go on to make a backtest of a buy the dip strategy with specific trading rules and settings. The strategy serves just as an example and you can probably make a better strategy yourself.

We use the 200-day moving average as a trend filter and we enter S&P 500 on a short-term buy the dip.

The trading rules read like this:

1. The close must be higher than the 200-day moving average.
2. The close today must be a seven-day low (of the close).
3. If 1-2 are true, then go long at the close.
4. We sell at the close when the close is higher than yesterday’s close.

This is a slightly changed version of the Double seven strategy by Larry Connors.

The equity curve of the strategy looks like this:

There are 329 trades, the average gain per trade is 0.52%, and the win rate is 76%. CAGR (what is CAGR?) is 5.7% while buy and hold is 9.5%. However, The strategy is invested only 16% of the time. If we divide the CAGR by the time spent in the market, we get 35%. This number is arguably the risk-adjusted return (what is risk-adjusted return?).

Why do we backtest? Backtesting and a data driven trading approach is no sure thing, but at least you have an idea that something has worked in the past – you have historical performance and performance statistics. If it has not worked in the past, you can skip it immediately!

Get the code for the strategy

Since we started this website in 2012, we have published plenty of profitable free strategies. You can get access to those plus the one strategy we backtested in this article. All strategies come with descriptions in plain English (for Python traders) and Amibroker code. Some also come with Tradestation code. You get a full list on the banner below:

Buy the dip strategy – ending remarks

There are plenty of ways to trade the “buy the dip” strategy. Long-term investors might buy any retracement bigger than a certain percentage level, while short-term traders might enter on pullbacks in a rising long-term trend, just like we backtested in this article.

FAQ:

– How does the “buy the dip” strategy work?

The strategy involves purchasing an asset during a period of downward price pressure, with the expectation that the price will recover. Investors typically hold cash or lower-risk assets, waiting for a significant price decline before buying the asset at a lower cost, potentially enhancing future returns.

– Is “buy the dip” a long-term or short-term investing strategy?

“Buy the dip” is generally considered a long-term investing strategy. It involves taking advantage of short-term price declines to accumulate more of an asset with the anticipation of long-term value appreciation.

– What are the risks associated with the “buy the dip” strategy?

While the strategy can be profitable in long-term uptrends, it carries risks, especially if price declines persist due to fundamental or macroeconomic factors. Timing the market during prolonged downtrends can be challenging, and investors must carefully evaluate the risk and reward of dip-buying.