Buying the dip is suddenly back in fashion again just one week after stocks ripped off their lows.
We’re not surprised. After all, traders have tossed around the term “buy the dip” so much during this bull market that it has taken on a life of its own. The short saying has morphed into a cheesy market meme all the pundits trot out whenever stocks drop.
Not sure what to do as the major averages get volatile? Just buy the dip and your troubles will melt away.
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But what does “buy the dip” really mean?
It’s certainly not a sound piece of investing advice. It’s vague and misleading, causing most investors to twist “buy the dip” into a catch-all excuse for their careless behavior.
Today, I want to spare you some pain and suffering by making sure you know how to successfully (and safely) buy the dip.
That’s why I’ve made a list of three rules you need to master. Not only will these buy the dip rules help you figure out how to translate investing’s most misunderstood mantra — they’ll also show you exactly how to avoid mistakes and execute the perfect trade.
Let’s get started.
1. No Knife Catching!
Just because a stock has dropped does NOT mean it’s putting in a buyable dip.
If successfully buying the dip was as easy as finding a stock that has gone down a lot, buying it, and waiting to collect your money, you wouldn’t be reading this note. I would be retired and living on my own private island somewhere in the Caribbean.
So when you’re looking to buy a dip, don’t go chasing after a stock with a chart that looks like a train wreck…
2. Find a Long-term Winner
Now it’s time for the next step: Finding a stock that has a good shot at rallying off its recent lows.
You want stability and a solid trend. Take 30 seconds and pull up a simple long-term chart of a stock you like going back at least one or two years. If the stock is moving bottom left to top right, you’re on the right track. No fancy technical analysis required.
Your best bet is a stock that’s proven itself and has a relatively strong chance to continue its trend higher. In the flip side, it’s probably not wise to buy the dips on some speculative garbage stock. Those are the kinds of plays that force traders to get in and out before they get chopped in half by wild sentiment swings. That’s not buying the dip. It’s a disaster waiting to happen.
3. Confirm the Bounce
You’ve thrown out all the falling knives and you’ve found a stock you like in a prolonged uptrend. Now you have to figure out when to pull the trigger! After all, buying is the most important part of this whole process.
But there is a catch (and no, it doesn’t involve a falling knife).
You can’t just buy any ol’ dip. You must wait for the right bounce to come along before scooping up shares. Here’s how you do it…
First, you need to get an idea of where your stock should bounce.
How do you figure that out?
You can draw a line or use a moving average that fits the trend — whatever works best.
Remember the SPDR S&P Biotech ETF (NYSE:XBI) chart I showed you Friday? Take a look at this ETF bouncing off its 50-day moving average one more time:
As you can see, XBI doesn’t perfectly bounce off its 50-day moving average every time. But you don’t need to wait for perfection. Sometimes, a stock will bounce off your trend line or moving average. Other times, it will overshoot or bounce before it reaches your target. The key is to watch and wait. You take what the market gives you.
Your final step is to wait for the stock to close higher than it opened on the day. That way, you’ll know you’re buying a dip heading into an authentic bounce — instead of a potentially hazardous false move.
Now you have a good grasp on how to buy the dip for consistent trading gains. It takes some planning and discipline. But if you take a little bit of time to plan your bounce trades, you’ll have a much better shot at eliminating some of those pesky losing plays. Instead, you’ll have a shot at picking up the stock you want at the best possible price — without taking on a ton of unnecessary risk.
This article originally appeared on The Daily Reckoning.