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.