What to Know About ‘Buying the Dip’ When Volatility Spikes
New tastylive research indicates that investors and traders may want to tread cautiously when attempting to "buy the dip"—especially during periods of elevated volatility in the financial markets
The contrarian approach to trading and investing has been around forever. Back in the early 1600s, when the Dutch East India Company became the first corporation in history to publicly offer shares, there was undoubtedly someone out there willing to bet against it.
This philosophy of trading has enjoyed a resurgence in recent years, after “buying the dip” surged in popularity during the onset of the COVID-19 pandemic.
Buy the dip refers to a trading/investing approach that involves purchasing an asset (or group of assets) after a drop in price. The goal when buying the dip is to make gains on a potential reversal in the price of the underlying asset.
For example, if the price of gold suddenly dropped 20%, a herd of contrarians would undoubtedly be drawn to the precious metals sector, hoping to profit from a rebound in prices.
Back in March of 2020, bold contrarians stepped into the stock market and ultimately catalyzed an epic reversal. The S&P 500 hit a low of roughly 2,300 in March of 2020, and then proceeded to rally all the way to 4,700, before correcting sharply in 2022.
Dip-buyers in 2020 benefited immensely from the quick reversal in prices, and the after-effects of those events are still rippling through the investment community. Today, there’s even a new ETF that features the dip-buying approach, known as BTD Capital Fund (DIP)—BTD being an acronym for buy the dip.
Moreover, net inflows into stocks and ETFs this year are +$120 billion (as of mid-December). What’s notable about that figure is that the stock market usually experiences net outflows during down years—as observed back in 2015 and 2018.
The previous success of buying the dip in 2020 has been a key factor in driving fresh capital inflows in 2022. But new research conducted by tastylive indicates that investors and traders may want to tread cautiously when attempting to buy the dip—especially during periods of elevated volatility in the financial markets.
To learn more about this new research, check out the details below—or dive straight into a new episode of Market Measures on tastylive.
Historical performance of buying the dip
Back in 2020, dip-buying contrarians experienced widespread success after the stock market rebounded in spectacular fashion.
But that doesn’t mean that every instance of dip buying will produce the same results. Past returns in the stock market certainly doesn’t guarantee the same performance in the future.
To evaluate the historical success of buying the dip, the tastylive research team examined all potential instances of buying the dip in the S&P 500 going back to 1993. And to better understand the risks associated with buying the dip, the tastylive team also incorporated historical levels of volatility into the equation.
As shown below, this research illustrated that the S&P 500 does indeed tend to produce large-magnitude, positive returns (i.e. big rebounds) when the CBOE Volatility Index (VIX) is elevated.
When the VIX pops above 25, the average change in the S&P 500 over the ensuing 45 days was higher (on average) than when the VIX is below 25. These statistics suggest that dip-buying can be a profitable endeavor when fear has overtaken the financial markets.
However, the tastylive team also found that risks increased substantially during such periods, meaning the variability of returns also spiked when the VIX was trading above 45. That means the risk of a sharp downside move also grows in likelihood when the VIX is higher. In turn, that means dip buyers could be at risk of severe capital drawdowns during such periods.
Taken altogether, the aforementioned research suggests that while dip-buying can be a profitable endeavor when volatility pops, it’s also a high-risk approach.
Investors and traders need to be cognizant of these risks when trading in such conditions, and be prepared to accept severe losses if things don’t pan out as expected.
For more insight into the historical success of buying the dip in the S&P 500, check out this new installment of Market Measures.
To follow everything moving the markets during the remainder of 2022 and beyond, watch tastylive, weekdays from 7 a.m. to 4 p.m. CDT.
Sage Anderson is a pseudonym. He’s an experienced trader of equity derivatives and has managed volatility-based portfolios as a former prop trading firm employee. He’s not an employee of Luckbox, tastylive or any affiliated companies. Readers can direct questions about this blog or other trading-related subjects, to support@luckboxmagazine.com.
