Buying the Dips – A Tapestry of Technical Tools and Strategy

Summary

  • The market shows it moves in the most vivid way, presenting many opportunities to enter a trade and book a profit.
  • One such opportunity presented by the market is often in the face of a dip in an uptrend; however, not every dip is worth buying.
  • So, how to identify which dip to buy, which is to ignore?
  • Tools and strategy at one’s disposal to identify potential profitable dips to buy.

Buying the dips is typically a phase used by traders to define purchasing of stocks or any other financial assets, which has declined in price, and buying dips works out differently for different people depending upon the context in which it is applied and the ability of a trader to identify major directional trends.

Understanding Trend – The Key to Buy on Dips

Trend is a very simple concept, yet it is considerably difficult to follow in practice. Almost all mechanical trading systems, which have made some money in the market, have been based on the simplest concept of jumping on a trend and riding it to its inevitable and perceived end.

Dow Theory – The Foundation Stone of Trend Analysis

Charles Dow was one of the first of modern technicians to write about the fact that the financial market trade in trends and investors or traders must focus on the time horizon most favourable to their circumstances.

  • Dow suggested that trend are fractal in nature, i.e., their behaviour remains the same regardless of the time frame.
  • Moreover, Dow suggested that there were three principle time horizons – the primary, the intermediate, and the minor, which Dow likened to tides, waves, and ripples.
  • Dow’s final and perhaps the most important observation was that trend tends to continue rather than reverse, and a trend is influenced by its preceding larger and next smaller trend.

The ideology behind the third observation is that the longer trend will influence the strength of the trend of interest, and the shorter trends will often give early signs of turning in the direction of the primary trend, and typically short-term trends reverse before medium-term and medium-term trends reverse before long-term.

Understanding these basic subjective observations is the key to understand a trend and inturn the art of buying the dips.

Directional Trend – How to Identify Them? Tools at Our Disposal.

There are primarily three directional trends that exist in the market, i.e., an upward, downtrend, and sideways (or consolidation), in which, buying the dips in a primary downtrend does not make much sense unless the rationale is backed with some quantifiable trading strategy with some strong back-tested results.

Directional Trend

When a peak and through occur at higher price levels than the immediately previous peak and trough, the trend is said to be an uptrend and vice versa.

Additionally, it should be kept in the mind that the steeper the angle of an uptrend, the higher is the strength of bulls, but higher chances of a dip opportunity.

In retrospect, identifying a trend is relatively easy; however, the difficulty, from an analysis standpoint, comes in being specific enough to determine when the sign of a trend change is leading to a change in primary trend direction as against a change in secondary trend, and this is often the point where one should avoid buying the dips.

Tools at Out Disposal To Identify the Primary Trend and Potential Reversal

  • Using a Regression Line

A mathematical formula which can fit two sets of data, such as price and time, to a straight line, which is known as the regression line.

  • The regression line has mainly two variables, i.e., starting point and its slope, and primarily technical analysts are interested in the regression line’s location on the chart and to some degree, its slope.
  • With the emergence of computer-based statistical tools such as TA software, programming languages such as R and Python, it is relatively easy to put a regression line and check for its direction.
  • The interpretation is that, if the regression line is sloping upwards with fewer outliers, the trend is upward and dips in such a trend could present an opportunity to participate in the upside rally.
  • However, on the contrary, if the number of outliers starts growing eventually in the opposite direction of the regression line, one should avoid buying successive dips as growing outliers in the opposite direction of the regression line is primarily considered as an early sign of a trend reversal.

To spot an outlier, technicians often calculate one or two standard deviations from the regression line to account for volatility and connect the points to form a band around the regression line. Any price point outside the band of standard deviation is considered as an outlier.

  • Trendlines

By far, the oldest and the simplest method for determining a trend, which mainly suggests connecting the peaks and troughs of a price action within the time horizon under consideration to form a line on a chart. An upward sloping trendline represents an uptrend and vice versa.

  • Drawing a trendline on a price chart is a method which is often at the discretion of the person analysing the chart. Typically, chartists connect the low of trading days to draw an uptrend line or high of trading days to draw a downward trendline.
  • Likewise, some chartists believe that the closing price is the most important price of the day and connect the closing price to draw a trendline, and when they do, it is often referred as internal lines.
  • The interpretation is that, if a price dip occurs and reverse from the support of the trendline (uptrend), it should be looked at as a zone to buy.

Furthermore, if the dip breaches the trendline support and confirms a trend breakdown/out, such a price dip should be avoided. Some chartists also use moving averages to confirm the strength in the trend, for example, a stock trading above an up-trending 200 DMA is considered as a strong trend when the shorter term moving averages, say 50 or 20 DMA are also trending up and below the stock’s current trading price.

Also Read: Volume Analysis- How to Utilise the Secondary Tool To Generate Alpha?

In a nutshell, various such tools are available at the disposal of a trader to identify a trend and reversal points, which along with some judgement, that. often comes with experience, should assist in buying or ignoring dips.

Technical analysis is often the tapestry of discipline, experience, patience, continuous learning, timely interpretation and implementation of basic tools, which often comes with time and efforts, so keep learning, keep profiting !!

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