Sell the rips and buy the dips. Like many Wall Street adages, this phrase rolls right off the tongue. But as many times as you’ve heard it or even said it, you may not have considered why it works or the driving principles behind it. That’s why we’re here.
Contrarians Are King
In order to successfully sell the rips and buy the dips, you must be willing to “fade” the market, to trade the opposite direction as the crowd. Being a contrarian sounds easy, but we’ve trained hundreds of young men and women to trade our money, and we can tell you that it’s far tougher than it looks, folks!
A contrarian approach tends to be the opposite of what most traders and investors have been taught and to their nature, as well. They’ve been trained to go with the momentum, not fight it. But following proven trends causes many investors to get caught when the music stops.
This is why our ‘StockMonster’ Guy Adami looks for blowout tops and bottoms, which are universally signaled by extraordinary volumes. Frenzy at the top or panic at the bottom either draws in the greedy or flushes out the fearful. While the rally is drawing in the novices, the smart money is quietly letting long positions go. Conversely, when panic is causing them to purge their holdings, you can bet that those buying on the bid are the professionals.
It turns out that selling the rips and buying the dips has roots in another trading adage: The only two things that move the markets are fear and greed. When the market is rising, the last thing on most traders’ minds is to sell. But if you’re riding a long position, then what, pray tell, is your exit strategy? You bought hoping to capitalize on a rally, but when you’ve got exactly what you were hoping for, what do you do next?
Investors should set a sell price for winners or losers before placing the trade. Lack of a plan will be hurtful if discipline isn’t exercised because the rally will tempt greed and the sell-offs will trigger a fear response. The thrill of picking a winner encourages you to hold for more, as more folks jump on the bandwagon and greed spreads like any other contagion. These greed-driven rallies lead to the explosive volumes that signal tops.
In contrast, when stocks collapse, traders can smell fear and react accordingly. The bears come out of hibernation to feast on the mistakes that careless longs have made, Wall Street’s equivalent of throwing gasoline on a fire. This year has been rife with textbook examples of how panic has been a vehicle for the bears to make untold billions. Anyone who watched or participated in the bear market of ’08 knows firsthand that fear drives markets down faster than greed drives them up.
How and When to Trade This Strategy
Selling the rips and buying the dips requires patience. The proper application of this strategy requires waiting for the trend to break before either selling or buying. Thus, when the trend is bullish, the strategy is to patiently buy the dips, then sell the rips. If you were to sell the rip first, you’d likely have to double down, selling more at higher prices before you got the chance to profit from a slide back to lower levels.
When we have a bear market, as we have since July 2007, the trend is down, so buying first would be a big mistake. Instead, patiently wait for rallies before selling the one- or two-day rips when the market returns to trend. The best part about selling rips in bear markets is that the rallies are so sharp and brutal that those quick, harsh rips boost your profits.
How Options Boost Sell-the-Rips, Buy-the-Dips Trades
Between us, we’ve traded for 44 years and counting. But even with that much experience, we hesitate to use the sell-the-rips, buy-the-dips strategy without proper protection. In our case, the protection comes from our use of calls, puts, or spreads involving the same. Instead of selling stock in a bear market rally, we establish a put spread, which gives us the opportunity to make money with limited risk when the market corrects to the downside. The open-ended risk of a naked short stock is something we can live without. Why should we take more risk when the job of a good trader is to constantly focus on maximizing reward while limiting risk?
If it were a bull market out there, we’d be buying a lot of call spreads when the market dipped rather than buying shares of stock. Again, we’re seeking to minimize and define risk while maximizing our returns with these derivative trades.
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Pete and Jon Najarian are the co-founders of optionMONSTER.com, a publisher of news, perspective, and market intelligence on options and equity trading. Their research and analysis is widely cited by financial media. Jon Najarian has developed patented trading applications used to identify unusual activity in stock, options, and futures markets. Pete Najarian co-founded the Hedgehog trading platform and is a cast member of CNBC’s ‘Fast Money’ program.
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