After we’ve identified quality stocks we want to add to our portfolio, we use The Dip Factor to help us determine when we will actually invest in these awesome enterprises.
Sometimes, buying low and selling high is not as easy as some people might think. As patient long term investors, we know that time in the market is more important than timing the market. But we still like to think we buy our stocks at sensible prices.
The Dip Factor is a simple method to help tilt odds a little more in our favour and to ensure we buy stocks with some kind of margin of safety.Measuring the Usual Price Drops of a Stock
The secret to The Dip Factor is to utilize the typical variations of the value of each security.
By measuring the differences between the peaks and valleys of the price of a stock, we can calculate 3 key values for each stock: the lower significant price drops (Low), the average price drops (Average) and the higher significant price drops (High).
A price drop exactly corresponding to the Low Key Value will result in a Dip Factor of exactly 1, an exact price drop equal to the Average Key Value will have a Dip Factor of 2 and a price drop equivalent to the High Key Value will have a Dip Factor of 3.
1 = Low
2 = Average
3 = High
Note that High is not equal to maximum.
Every other values in between can be extrapolated.
So, in our example:
Price drop of 7 % => Dip factor = 1
Price drop of 9.2% => Dip factor = 2
Price drop of 12 % => Dip factor = 3
…
Price drop of 0% => Dip factor = 0
Price drop of 3.5% => Dip factor = 0 + (7% - 3.5%) / 7% = 0.5
…
Price drop of 9% => Dip factor = 1 + (9% - 7%) / (9.2% - 7%) = 1.91
…
Price drop of 10% => Dip factor = 2 + (10% - 9.2%) / (12% - 9.2%) = 2.29
…
Price drop of 15% => Dip factor = 3 + (15% - 12%) / 12% = 3.25
Price drop of 24% => Dip factor = 3 + (24% - 12%) / 12% = 4
Price drop of 30% => Dip factor = 3 + (30% - 12%) / 12% = 4.5
…
How to Calculate Key Values
To calculate Key Dip Factor Values (Low, Average and High) for each stock, you have to measure price drops of each security over a significant period. We like to do it over at least 3 years.
For instance, StockCharts.com can provide an easy way to accomplish this using their weekly chart.
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On the chart, each significant price drop can be measured and ensuing results can be compiled. From our example for Coca-Cola (KO), the drop from 39.96 to 36.10 will give a result of 9.65% [(39.96-36.10)/39.96].
You should get at least a dozen different results for a 3-year period.
Most of the results will be clustered with a couple results above and below the cluster.
The Low will be the lowest value of the cluster (rounded to the nearest half-percentage).
The Average is simply the average of all results.
The High will be the first value over the cluster (rounded to the nearest half-percentage).
Rounded High and Low values are easier to visualize, can be quickly analyse and also simplify calculations.
Comparing Drops for Different Stocks
Because calculated key values associated with the Dip Factor are different for every security, it can help you compare the relative drops of several stocks.
By definition, more volatile stocks normally experience more important fluctuations thus their key trigger percentages will be higher. In the same matter, conservative stocks that don’t fluctuate as much will have lower key percentage values.
So, a riskier stock will have to drop much more than a safer one to be considered as attractive using the Dip Factor.
For example:
Coca-Cola KO (1=7%, 2=8.82%, 3=10%) stock price would have to
decline only 10% to result in a Dip Factor of 3
But Apple AAPL (1=9%, 2=12.05%, 3=15%) would have to
drop by as much as 15% for the equivalent Dip Factor of 3.
Likewise, respective drops of 20% for KO and 30% for AAPL
would be necessary to achieve the same Dip Factor of 4.
In that matter, the Dip Factor is an effective additional tool we use to compare relative values of our favorite Watch List candidates.
When to Buy
The Dip Factor helps us identify when to pull the trigger to finalize a buying decision.
In most situations, we consider that a Dip Factor of at least 3 is necessary to justify buying a new stock for our Portfolio or adding to an existing position.
Ideally, the higher the Dip Factor the better but you have to be extra careful when our indicator goes too high especially for more volatile stocks. You should become suspicious and find a probable cause before acquiring stocks with a Dip Factor of over 4.
So, a Dip Factor between 3 and 4 is probably the optimal way to ensure you acquire stocks at attractive prices while providing a sufficient margin of safety.
Hope our homemade tool helps you buy great stocks of your own.
Feel free to tell us about it!
Nice simple technique! I plan on trying it. I have a question. Is there a certain time span not to exceed between the peak and the low. Like, in your example, you identified the drop from 39.96 to 36.10. Why didn't you use the low of 34.37? Thks
ReplyDeleteHi Hugo, great question!
ReplyDeleteIt more about the trend changing than about a particular time span. Remember that the chart used is already in weeks so any significant change of direction can be considered a peak or a valley and it would probably be much more evident if you zoomed on it. By the way, StockCharts already does a great job of pointing out most of them although a couple are still missing.
If prices go sideways (like in the middle of the graph just under 39), it will only be considered if it goes in the opposite direction afterwards (so it's not a peak in this example because prices continue upward after the 39 stall).
Remember that this technique estimates and compares price drops and the important thing is to be consistent when you use it with different stocks (always use the same overall time period and judge potential trend changes the same way). The ultimate objective is to compare dips of several stocks so a 15-20% drop may be very attractive on a conservative stock (I like to buy this kind) but not at all on a more volatile one (riskier choice that I try to limit and avoid).
Hope this helps!
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