How to Trade a ‘Dip’ Vs. How to Avoid Buying a ‘False Dip’

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Let’s talk about how to spot a ‘dip’. Buying stocks or cryptocurrency on pullbacks is a tempting strategy and can be successful. However, it is also the case there are times when buying on a ‘dip’, is buying just at the start of a big down move! So, that is not a good plan.

This chart analysis is going to explain one way to identify good risk/reward opportunities to buy a stock or crypto on a dip. 

In the chart above, we will look at BTC, it is the symbol for Bitcoin futures and tracks the price of bitcoin that you can buy on coin base or other platforms. 

On the chart I have added two additional elements, a simple moving average (SMA), and the RSI(Relative Strength Index). The simple moving average is as the name implies a simple price average of Bitcoin over the prior 9 days. The blue line on the chart reveals the trend of prices of the prior 9 days and is used by traders to identify if a trend is going up or down. If the line is going up, the trend HAS been up. Of course that can change at any time.

The lower part of the chart has the RSI. The RSI often fluctuates between 30 and 70, but can go to extremes of 20 to 80 during times of a strong trend. The RSI, as the name implies is a relative strength index. In other words, if the stock/crypto is showing a strong trend up, RSI will be rising, and falling if it is showing a trend downward. 

 

The key is the number 50. 50 in a RSI screen is short of the middle ground, where buyers and sellers are trying to make up their minds of which direction to go.

 

In the chart the neat thing is when the prices retest or touch the SMA(blue line) AND the RSI bounces off around 50, not exact, you can see that is often a good ‘convergence’ of two different indicators that the price is likely stabilizing and potentially rising again. 

The white circles highlight 3 examples of the prior months when Bitcoin did just that. Each time the RSI got to around 50 and the price remained above the blue line or close to it and then made a strong move higher.

Key Point, combining the RSI with a SMA can be a powerful way to buy the ‘dips’ and have a good risk/reward trade setup.

 

How to Avoid Buying a ‘False Dip’

 

Buying stocks or crypto-currency on pullbacks can be a potentially profitable approach when the market is in an uptrend. One way is to find a convergence of technical indicators with price action to identify and enter low risk trades. 

However, there are also times when a ‘dip’ is actually the start of a big down move, and of course if you are looking to buy, that is something to avoid.

Also, in uptrends our minds sometimes only see ‘dips’, and because of our bias or optimism, or many other psychological reasons tend to have an easier time identifying positive expectations rather than negative expectations. In trading this is a dangerous flaw and can lead to significant losses.

Therefore in this article let’s try to use some basic principles to help identify when a dip is higher risk to be a ‘false dip’, and rather a start of a down move.

In the screenshot above of the VXX, which is the volatility futures index, you will see the daily price bars. In addition, there is a blue line that is the simple moving average (SMA), this is the price average of the prior 9 bars. On the lower part of the chart is the RSI, or relative strength index. The RSI indicates the price “strength”. Essentially a rising RSI indicates improving price strength and a declining RSI indicates deteriorating price.

 

However, sometimes when the RSI hits 40, it is not a pullback but rather a sign of further weakness to come.

 

In the chart of VXX, you can see 3 examples of when the RSI hits 40 and further price deterioration occurs. 

 

The easiest way to identify this is check the SMA. In these 3 scenarios, the price is BELOW the SMA when the RSI hits 40. Each time, the price goes lower and buying those entries would have resulted in significant losses. 

 

Detailed Definitions

 

What is RSI?

“The relative strength index (RSI) is a momentum indicator used in technical analysis that measures the magnitude of recent price changes to evaluate overbought or oversold conditions in the price of a stock or other asset. The RSI is displayed as an oscillator (a line graph that moves between two extremes) and can have a reading from 0 to 100.” Investopedia 

 

What is the SMA?

A simple moving average (SMA) calculates the average of a selected range of prices, usually closing prices, by the number of periods in that range.” Investopedia

 

 

Any questions feel free to email me.
Ronak@rpmassets.com

Check out our blog about why teens should learn to trade-  https://rpmassets.com/top-6-reasons-teens-should-learn-to-trade/

Key Lessons for review:

What is a stock?

What is Price Support? 

How to Draw Stock Chart Trendlines

What is Earnings Per Share (EPS)

Ronak

ronak@rpmassets.com

www.rpmassets.com

 

-RPM Assets

The content on RPMAssets.com is intended to be used for informational and educational purposes only. Investing involves risk and it is important that you do your own analysis before making any investment decision. Obtain your own independent financial advisor before making any financial decisions.

 

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