The best way to buy this dip

Free After-Hours Analysis:

The S&P 500 recovered a big chunk of Monday’s losses as fears of a runaway Coronavirus epidemic receed. That said, there were not any concrete headlines supporting this change in outlook, just a wave of dip buyers jumping in and hoping for the best.

The bigger question is if this rebound is the real deal or just another sucker’s rally on our way lower. I wish I could tell you the answer, but predicting the whims of an emotional market is one of the most challenging things to do in the market. But just because we don’t know what the market will do doesn’t mean we cannot trade these swings intelligently.

If a person took profits proactively when the market broke above 3,300 or alternately, used a trailing stops to lock-in profits at this level, they should have cash available to take advantage of this dip. If we don’t know when and where this market is going to bottom, our plan needs to tell us when to act.  Obviously we don’t want to catch a falling knife, so that means waiting for a bounce. But how do when know when the market is really bouncing? Unfortunately, we don’t. That means our plan also needs to include contingencies for being wrong.

While Monday’s gap lower open was dreadful, prices bounced off those early lows minutes after the open. That is considered a bounce and is a great entry point. The biggest advantage is the early lows give us a definitive and close stop-loss level. Buy the bounce and hold on as long as prices remain above the opening lows. Easy enough.

This morning’s bounce also gave us a good entry point. Not quite as nice as yesterday, but we buy the early bounce and keep a stop at yesterday’s close. This entry is less attractive because we are buying at higher levels and the stop is a little further away, but it is still a decent entry with well-defined risk.

Typically we control our risk by starting with a smaller position and only adding money after it starts working. And while we start this trade the same way, this situation is a little more tricky because most of these Chinse headlines come in the middle of the night. That leaves us vulnerable to a dramatic gap opening like we saw Monday morning. For this reason, we might want to hold less risk overnight than we normally do. Or at the very least, acknowledge the increased risk and be willing to hold something that could jump past our stop-loss levels.

While buying the dip in the face of all of these spooky and uncertain headlines feels risky, if we follow a sound plan, the risks are actually quite modest. By the time it “feels safe”, the discounts will long gone, and in fact, the higher prices actually make the “safe feeling” time riskier. Jumping in at the lows with a sensible plan and well-defined stop-loss gives us both protection and profit opportunity. Hard to argue with that.

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Tags: S&P 500 Nasdaq $SPY $SPX $QQQ $IWM