Lesson 18: Buying on Dips
Mr. "A" is a 'market' investor. He trades only in the stock
of corporation 101. Whenever the price of that corporation declines,
Mr. A buys its stock. He has no particular program for buying; he
buys when he feels like it. "Buying on dips" is what he
calls it.
This method worked great for Mr. A from 1990 to 1999. As the price of
the stock of corporation 101 went from $3 to $100, this gentleman
made a lot of money. "Buy on the dips" is what he was
reported to have told his friends and neighbors and business
associates, some of whom followed his advice and some of whom did not.
Mr. A, our 'market' investor, did not have a defined program for
buying on "dips", but let's pretend that he did. Let's say
that Mr. A's program for buying on dips went something like this:
- Rule One: Whenever the price of the shares of stock of
corporation 101 close lower three days in a row, buy on the close of
the third day.
- Rule Two: Once the shares of corporation 101 stock have been
purchased, sell those same shares whenever the price of the shares
purchased advance $10 above the purchase price.
These are pretty simple rules. They are our rules, however, and not
Mr. A's. Mr. A might have used these rules or he might have bought
when the shares of corporation 101 declined four days in a row. Or
declined fourteen days in a row. Or, if there was a lower close even
two-days in a row. In fact, we don't know what Mr. A really did
because Mr. A is a hypothetical person created for the illustration
of 'market' and 'method' trading in commodity futures and options
contracts. There is no corporation 101 with its price rising from $3
to $100. There is no Mr. A and there is no Mrs. "B". But,
let's assume that there is and that Mr. A bought whenever the market
dipped and sold whenever the market advanced. We have created two
rules for Mr. A that he probably never had, but these two rules do
meet the criteria of buying on dips and selling on bulges and that is
all we need for the purpose of this example.
Suppose in the period from 1990 to 1999, an investor bought shares of
corporation 101 on "dips" and sold on "bulges"
and that the price of corporation 101 stock moved upward in those ten
years from $3 to $100 a share. How would the two above rules work in
such a market? They would work brilliantly. Buying at
$3 and selling at $13: Buying at $5 and selling at $15: Buying at $15
and selling at $25: Buying at $20 and selling at $30. Buying at $90
and selling at $100. All the way from $3 to $100, this method of
"buying on dips and selling on bulges" would have produced
tremendous profits for anyone who followed this plan. You
certainly could call these rules brilliant. They were just that. From
1990 to 1999, that is.
But did these same two brilliant rules work in the latter half of
1999, and in the year 2000? When the price of the stock of
corporation 101 was dropping from $100 to $20 a share, did these two
rules work then? They did not. What happens if you buy
shares of a corporation at $90 a share with an order to sell at $100,
if the price never rises to $100? What do you do if you buy at $80
with an order to sell at $90, if the price never gets above $85? What
do you do when buying at $70 with an order to sell at $80, and the
shares can't reach $73? And if you continue doing this all the way
down to $20 and the market won't even work its way up to $30, what do
you do then? Do the two rules that worked so wonderfully from 1990 to
1999 works just as wonderfully under these conditions?
-
Rule One: Whenever the price of the shares of stock of
corporation 101 close lower three days in a row, buy on the close of
the third day.
-
Rule Two: Once the shares of corporation 101 stock have been
purchased, sell those same shares whenever the price of the shares
purchased advance $10 above the purchase price.
Remember that Mr. A never actually used these rules. For our example,
the only rule he was ever quoted as having used was the rule to
"buy on dips and sell on bulges". When "dips" and
"bulges" come, one can make a lot of money doing this. When
only "dips" come, one does the opposite of making money.
From the middle of 1999 until the summer of 2000, Mr. A made 83
purchases of shares of corporation 101 stock. There were lots and
lots of times when the price of the shares of corporation 101 were
lower three days in a row between July and June of those two years.
There were 83 times, to be exact. Our hypothetical Mr. A bought on
each of these 83 occasions. Why not? He was a 'market'
trader who traded only the shares of corporation 101 and for nearly
ten years buying on dips and selling on bulges had always worked. Why
not continue with something that had always worked? Mr. A planned to
spend the rest of his career trading nothing but the stock of 101 and
whenever the price went down, he would buy it, and when it went up,
he planned to sell. Buy on the dips; sell $10 higher. Buy on the
dips; sell $10 higher. This had worked for Mr. A for ten years; it
should work for him forever. Shouldn't it?
Mr. A was a 'market' trader, but he was not a happy camper. Would you
be if you made 83 purchases of stock and every purchase resulted in a
paper loss? Mr. A was a market trader because he traded only one
market. It was corporation 101 all the way. He didn't consider
himself a 'method' trader even though he did use a sort of a method
for his decisions, buying on dips. In fact, Mr. A didn't even know
what the term, 'method trading', meant. There were some other things
that Mr. A didn't know. He didn't know about method-stacking™.
And he didn't know about Mrs. "B". He is about to find out.
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