How to Buy a Dip Without Buying a Dud
Snapping up a stock on a pullback can be a winning strategy for traders, but you have to know how to do it.
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Buying a dip or pullback in a favored stock is a very powerful strategy, but like most things in trading and investing, it is important to have sound tactics to minimize risk.
The biggest losses that many investors incur when buying a dig result from buying pullbacks too big and too quickly and then panic selling when they fail to see a bounce or recovery. Pullbacks in stocks that we are already invested in emotionally and financially can be very alluring. The inclination is to believe that the market is incorrectly pricing the situation and that this is a bargain that we should hurry to take advantage of.
Buying pullbacks in great stocks when market conditions are poor works well, but if you are going to take that approach, then you have to have a solid plan.
There are two types of dips or pullbacks. The first are those that are just a function of routine volatility. Day traders can make a good living buying intraday dips and flipping into strength. Extremely oversold stocks can deliver very powerful bounces, but this requires constant monitoring to catch the turning points.
There are numerous short-term tactics for buying dips and pullbacks that I will discuss in future posts. Traders often use tools like Volume Weighted Average Price to time entries, and news events often offer exceptional opportunities for dip-buying trades.
The second type of dipping buying is longer term and is used to build investment positions. One very common strategy of big funds is to constantly look to lower their cost basis. These funds are focused primarily on valuation, and so when they see a chance to lower their cost basis in a favored stock, then they will do so. The key here is that they are confident that fundamental conditions are still intact and their price targets are still valid.
Big funds will have very strict rules about how much exposure they will have to any one stock position. They are not going to keep buying just because a stock is becoming cheaper. They have to have risk control, and that means keeping position sizes small enough so they can't do huge damage in case their research is wrong.
Individual investors have a much greater tendency to become overly concentrated in a favored name. They may not have much capital to work with and don't want to be over-diversified.
The biggest problem that is averaging down presents is how you keep buying when the stock keeps falling. The answer is that you don't. You have to constantly adjust the position size into routine volatility to keep it from getting too big.
There are a number of small-cap stocks that I like in the longer term, but they may languish for months while waiting for catalysts. I can't just keep buying them and build up a huge long-term position because that would be poor risk management. So, what I do is constantly trade the short-term volatility. I'll reduce when I think I will have a chance to buy lower, and then when I do buy a pullback, I'll look for the chance to sell some into minor strength.
This approach can be very tricky because surprise news can hit at any time, and you can miss out if you are too aggressive with the shorter-term trades.
My best advice for building long-term positions with dip buying is to not be afraid to sell and rebuy. The focus should be on keeping the position size small enough so that you always feel that you can buy more. If the stock is fading in a poor market, then sell some and then start thinking about where it makes sense to rebuy.
You want to shift your mindset away from just endless buying and shift to positioning and more accurate timing. The main variable is the position size and not the entry point.
I'm currently using this strategy with Humacyte HUMA , which is a low-priced small-cap that is expected to have some significant news before the end of the year. I'm optimistic about the situation, but I am constantly shifting my position size as I deal with the routine volatility. I'll have more on this name on in the weeks ahead.
(Please note that due to factors including low market capitalization and/or insufficient public float, we consider this stock to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.)
At the time of publication, DePorre was long HUMA.
