If you followed the markets over the last couple of days (and I trust you did) then you saw what’s happening:
Most markets have lost about 8% of their last heights. 2 months of gains have been erased within only 2 days.
Now that sounds bad!
There is nothing too surprising about it. It is a correction that most traders have been anticipated. Average long-term gains in the stock markets are 7-8% per year. In January 2018 alone, the SP-500 had gained 6.5%!
Markets have been “overbought” for a while now, and the exponential growth experienced over the last several months cannot be sustained in the long run.
And it is probably not over yet!
So what to do?
If you have your trading system with proper stops in place… nothing. Let the system do its job. And then… go shopping!That’s right. It’s discount time!
The market fundamentals are sound – there is no evidence of a crash, recession or bear market.
That’s why this is a buying opportunity. Stocks that previously appeared expensive are coming down to acceptable price levels.
How to buy the dip?
Ideally… buy at the bottom just before the rebound.
Unfortunately, that is impossible. We cannot know when this happens. It can be tomorrow, or in a week, or longer.
Here’s how to do it right:
- Identify the stocks you want to buy at a discount
- Buy some and wait. If the decline continues, buy some more
This means, apply diversification – over stocks AND time.
Let’s look at each point in detail.
Find your favorite stocks to buy
If you ever felt like you “missed the train” about buying a certain stock, now is the time to look at it again.
This happened to me with NVDA (Nvidia). I always thought that stock is expensive, so I did not buy it, just to see it continue its growth. Here’s how buying into NVDA would look like:
1) Buy a small position now at the current low price
If the stock price increases afterward (i.e. the dip is over), then keep it as is.
2) If the decline continues, buy some more at a lower price
And that’s it. After that, sit down and wait. If the company fundamentals are sound, prices will recover and growth will continue.What about Stops?Yes, you should definitely set stops to control your risk. Here’s how to do it:
- Choose a stop price that is 25% below the buy price
- That will automatically reduce your position size to a smaller one
- 25% difference is most likely enough to ride out this dip
Example with NVDA, a 50k$ portfolio size, and risk of 1% per trade:
- 1% risk = $500
- Buy Price est. = $213.70
- Stop Price est. = 0.75 x $213.70 = 160.30
- Stop Difference = $213.70 – $160.30 = 53.40
- Stocks to buy = $500 / $53.40 = 9.4 = 9 stocks
- Cash needed = 9 x 213.70 = 1,923.30
If you buy a second position, use the same 25% stop.
If you have no favorite stock…
In such case, do a quick analysis. Which stocks have been affected the most, which ones the least?
Here is how that could look like:
There are two ways of looking at it:
- Buy stocks that declined most, as long as you trust that the company’s business is sound
- Buy stocks that declined least, because that shows they are “strong” or not overbought.
It’s up to you. You can buy some of both types if you are uncertain.
A word of caution
This dip buying strategy is called “averaging down”. In this situation (assuming that there is no bear market), it is the right thing to do.
But don’t do it in a bear market! This only works well for bull markets and buying during price dips.