Market players lose more money from improperly buying dips than any other action. Traders who go broke typically do so by averaging into a downtrending stock too big and too fast. It is extremely easy to be undisciplined in buying dips and pullbacks, and the losses can be huge when a thesis proves incorrect.
However, dip buying, when done right, can produce exceptional gains. Some of the best opportunities in the market are in stocks that are being unfairly sold. Catching the turn at the right moment is not only very satisfying but extremely lucrative.
To become a master of the dip buy, the first thing to understand is that there are three basic types of pullbacks.
The first are the index-driven dips that are actively traded by computer algorithms. This action is much different from what tends to occur in individual stocks. Lately we have seen this on an almost daily basis. Traders often refer to the "10:30 dip" because it has become so automatic. The computer algorithms pounce on these plays, which often are very small, but this is the bread and butter of much of the program trading that occurs every day.
Very complex algorithms are employed for this sort of dip buying. The programs will use news headlines, price action and other factors to design their approach. News events like the Fed or unemployment reports often trigger these events.
Overall, it is a very different type of trading than buying pullbacks and dips in individual stocks.
There are two basic types of dip buying in individual stocks. First is the gap-down play. Celgene (CELG) is a good example of this type of play.
The second type of dip buying in individual stocks is the downtrend play. A good example of this is Flexion Therapeutics (FLXN) , which has been down 13 of the last 14 days as I write.
Gap-down plays like CELG usually come with a surge in emotion and increased volatility. There will be a faction of traders who will argue that the selling is overdone, and there will be another faction who will argue that all the bad news is still not priced in.
We saw an example of the latter when CELG gapped down last week. Brave dip buyers were stung badly when more bad news was released on Thursday.
Often a stock with a big gap down will see a quick reflexive bounce, but the danger is that stuck holders will want to banish the stock from their screens and look for an escape. They will sell into bounces, and that is what overhead resistance is all about.
There are two basic ways to play CELG. Either you try to catch the very fast overreaction that did work intraday yesterday. The second approach is to wait a few days and see if the stock finds support. Traders I know often will take positions on the third day after a gap-down open if they have confidence in the stock.
Dip-buying individual stocks that are in a downtrend has a very different psychology. These situations can be very ugly traps for those who are not careful. The slow drip lower can continue for a very long time as stuck holders eventually give up in disgust. They figure they are failing to understand what is pressuring the stock, so they finally dump it and move on.
On the other side of that trade are often the traders who are convinced the market is wrong and that it will eventually discover its mistake. Often they are right, but if they do not control their risk, they can suffer grievous damage. You simply cannot allow conviction to overcome discipline. You have to take that loss at some point no matter how confident you might be in the fundamentals. As the saying goes, the market can remain irrational far longer than you can remain solvent.
Here is a chart of Flexion Therapeutics, which is on my dip-buying radar. I took a position on Thursday.
Charts don't get much uglier than that, but I believe the stock has been unfairly punished due to the opioid crisis that has been in the news lately. The stock dropped further on comments by President Trump on Thursday and I believe this may have set up a turning point.
I don't really know enough about the fundamentals to make any judgment about how this issue will impact the stock, but with the recent secondary pricing at $25.50, the discount is substantial. The key here is to control risk. Buying an ugly chart is only more risky if you don't use stops. I'll place my stop to keep any loss small and will take some partial profits quickly if I have them. The stock really needs to find support before you can hold bigger positions.
Dip buying can be very difficult, but the effort can pay off big. Just make sure you control risk.