What ‘Buying the Dip’ Really Means (And When It Becomes a Falling Knife)

“Buy low, sell high” has long been popular advice that traders try to follow. For those applying that advice, there is one strategy rooted in this principle: buying the dip. Traders can utilize tools such as stock screeners to identify securities that meet the criteria of a dip. In addition, the best online brokers provide traders with risk management tools designed to help them mitigate losses when holding stocks that are trading at unusually low prices. But whether or not a stock is experiencing a temporary plunge in value or is destined to decline a lot further—becoming a falling knife—depends on important fundamental and technical factors, which we aim to cover.

What Does It Mean to ‘Buy the Dip’?

Buying the dip is a fairly straightforward approach. During a bull market, when the optimism for the outlook of stocks is high, traders can still find individual stocks whose prices have recently experienced a significant decline. If a stock has promising fundamentals, traders can buy at the depressed price point with the expectation that the stock will rebound enough to generate a profit. That’s the formula for successfully buying the dip. However, before traders buy the dip, they must understand trading psychology to avoid making rash decisions in the market. While the basics of the strategy are simple to apply, traders should recognize when it makes sense for them to buy the dip.

When Buying the Dip Makes Sense

A dip can occur at any time for any reason; it can be caused by investor reaction to a stock’s fundamentals and other traits. Or it can be caused by external factors such as bad publicity, legislation, and geopolitical events. The stock market is a sensitive, complex financial ecosystem. To determine if buying the dip makes sense, traders should understand the sector in which a company’s stock operates and review company filings, such as 10-K and 8-K reports, as well as financial ratios such as the following:

• Gross profit margin: The gross profit margin is the total revenue minus the cost of goods sold. For example, if a company has a total revenue of $1 million and its cost of goods sold is $800,000, the gross profit is $200,000, or 20%. An acceptable margin will differ for each sector and individual factors.
• Earnings per share (EPS): The EPS gauges a company’s profitability. Generally, the higher the ratio, the better; however, that is not guaranteed. The metric is usually already calculated for those conducting their fundamental analysis. To determine this number, traders divide a company’s net income by the number of its outstanding shares.
• Price-to-earnings ratio (P/E): The P/E ratio is an economic indicator that helps traders determine a company’s potential for growth. It does that by disclosing how much money investors are willing to pay for every dollar a company earns in profits. To get this ratio, traders divide a company’s stock price by its EPS. Generally, the lower the P/E ratio, the better, in the sense that each dollar of profit is less expensive. However, keep in mind that a competitive P/E ratio can differ for each stock. And some highly profitable stocks can be very expensive due to supply and demand.

What Is Catching a Falling Knife?

At first, a falling knife situation may display many of the same characteristics of a dip. However, there is one detrimental difference: With a falling knife, the stock’s price keeps falling, seemingly with no support from previous chart levels. The chart below shows META Platforms from 2017 to 2023, and is an excellent example of a falling knife. Between Feb. 2 and Feb. 3, 2022, the share price sharply declined (losing nearly $100 in share value) and continued its decline until it bottomed in November of 2022.

When we take a deeper look at this example, those who bought the initial dip in the second half of 2021, as META was testing the $300 area, most likely expected the stock to stabilize above that area. Unfortunately, in this particular case, traders found themselves in a falling knife situation as the stock’s price went lower in the months that followed, crashing through key support levels near $150 and $125 along the way, before the stock started to recover. 

How to Avoid Catching a Falling Knife

Even if you’ve conducted deep research before buying a dip, there is always the risk that the dip can deteriorate into a falling knife; it’s a harsh reality. The best practice, especially for novice traders with small accounts who find a dip, is to stay on the sidelines and let the market resolve itself.

Patience is a virtue when it comes to investing. Arriving late to a rally is always better than arriving early to a crash. However, investors who are adamant about taking on the risk and buying the dip should consider placing parameters around their trades, which can create a safety net for their portfolio. Here is what to consider when using your trading platform to perform risk management:

• Stop-loss orders: A stop-loss order lets traders limit a loss. If a trade turns into a falling knife, the trader can close out of it at the price they set with a loss that they’ve decided in advance they can tolerate.
• Hedging strategies: Put options can be an effective hedging strategy. Traders can establish a put option for stocks they invest in when entering murky territory, especially when upcoming earnings reports can further sink a stock. In addition, inverse ETFs are sophisticated instruments designed to use various derivatives to gain value from the declining underlying asset.

While there is no guarantee that investors can safeguard themselves from ever catching a falling knife, traders can ensure they are giving themselves the best possible chance to mitigate potential losses.

The Bottom Line

Buying the dip can be an effective tool that complements your trading strategy. However, as with any market strategy, there are risks. A dip can quickly turn a seemingly attractive buy into a terrible investment. The best way to protect your financial assets, after conducting fundamental research, is to hedge your positions or establish stop-loss orders. If you need further assistance, you can always seek guidance from a financial professional.