Buy the Dip in 3 Easy Steps (And One Major Error)

AOTB Mini-Series

The present lesson is a simple one and it’s probably best expressed in a chart.

I am going to try to explain why it makes rational sense to buy when the market has crashed down a lot and is just about to break through key support levels–with one major exception.

It draws on material from Lesson 8 of The Absolute Beginner’s Guide and I’ve been discussing this point with coaching clients all week. The main thing you need to do is prepare for both eventualities–a positive bounce and a further (unexpected) decline.

Since we’re in a dip right now, I’ll also give you my assessment of the market and why I’ve been skeptical that this is the end of the run. These are supposed to be short, so let’s start with the surrounding context.

The Logical Context

The main reason I love dips turns on the opportunities they offer for better risk adjusted returns. My goal is to beat the benchmark in performance, and in the crypto world that benchmark is Bitcoin’s performance.

I’ve been going out of my way recently for Bubble and Crypto Riders to make clear how much my strategy is out-performing that benchmark (better than 23% last week alone). And there are a few simple techniques that I use to do this.

The intelligent use of reward to risk ratios is one such technique.

The Logical Context to Buy The Dip

The logic behind this analysis, to recall, is this. Suppose you have a bet where the reward to risk ratio is 1 to 1, then you will need to have better than a 50% chance of winning to make money on several such bets over time. Let’s say you’re betting $100 each round.

Bet 1: Win $100
Bet 2: Win $100
Bet 3: Lose $100
Bet 4: Lose $100

With that 1 to 1 ratio and a 50% win streak, you’ll come out exactly where you started.

Suppose instead that you have a 3 to 1 reward to risk ratio. How often do you need to win then?

Bet 1: Win $300
Bet 2: Lose $100
Bet 3: Lose $100
Bet 4: Lose $100

You’ll even out your gains with a 3 to 1 ratio if you have a 25% chance of winning.

In general, solid dip buying allows you to get those 3 to 1 reward to risk ratios, so even if you are wrong about them a whopping 70% of the time, you’ll still make money long term. That’s why they’re attractive.

With that in mind, let’s try to apply it by returning to our main chart

Step 1 – Have a Good Momentum Indicator

What we’re looking at is the TOTAL, which is a composite of the market cap (= price per coin * total number of coins) of all the major crypto currencies. You’ll see that it’s been trending down for about a month.

You’ll also notice a white line. That the simple moving average of the last 160 days. This is a robustly supported momentum indicator. My own algorithm uses a slightly modified version of that, but you’ll make plenty of money using just that (for more details, see Lesson 7 from The Art of The Bubble Guide).

When momentum trading, the trend is your friend, so if the price is above the moving average, then you should hold onto your cryptos, and if it falls below, then sell your cryptos. In that image, the price is still hovering above the SMA 160, but it’s close to falling below.

Notably, it must close below that line to count as “falling below” and not simply cross below it during the trading day. I use closing prices because that eliminates a lot of false signals (review that problem from Lesson 7 of The Absolute Beginner’s Guide).

Step 2 – Calculate Reward to Risk

Ok, now that we know what signal we’re using to assess our trades, we can do the reward to risk thing.

A Calculated Approach To Buy The Dip in Three Mere Steps

When the price has closed right on the line, you have the best reward ratio because you are likely to sell out with an 8% loss on the high end. Why? Well, you’ll sell as soon as you get a close below the line (that’s the SMA 160 strategy). It might only be 1% below and it’s unlikely to be more than 10% in a day (that’s very rare for cryptos). So, 8% is a rough guess for a trade gone wrong.

Approximate guesses are what you’ll get doing this. No one owns a crystal ball.

Now look at the possible reward. The closing number (above the SMA 160) is at $2.14T and simply a return to the all time high ($2.9T) represents a 35.5% bounce up. That’s actually better than a 4 to 1 reward to risk ratio.

Our target for a trade like this is a 3 to 1 reward to risk ratio and this opportunity has a better estimated ratio. That gives us some margin of safety.

Step 3 – Optimize for Rewards

The weird thing about what we’re doing is that we’ve been looking at the TOTAL which is not a single coin. The reason for that is that we’re checking for industry health and using the TOTAL as our lead indicator (I also use BTC).

Review Lesson 4 (on lead indicators) and Lesson 9 (on the basic economic cycle) to understand the more general process at work.

That means we’re going to have to pick a coin to execute this on. Bitcoin often bounces back first in a bounce, but it doesn’t often bounce the most. Historically Ethereum bounces more. So, let’s throw up the ETH / BTC (Ethereum price in terms of Bitcoin price) chart.

These charts are from TradingView incidentally, and here’s my little link to get you a discount if you want their paid stuff (I’ll make $10 I think, and save you $30).

Ok, so you can see that Ethereum has been on a stead rise against BTC for a while and it’s presently still above the SMA 160, even if it’s recently dipped. Going with the idea that the trend is our friend, then it’s a better bet to choose ETH over BTC, given prevailing market trends.

By contrast, Cardano (ADA) has poor momentum relative to BTC.

I think the project is over-hyped anyway, but for a bounce trade, its moment dynamics aren’t favorable.

So, a coin like ETH is better positioned for a bounce. For you Degens out there, you’d pick the ETH 2x coin (knowing that things can go wrong fast).

A Looming Mistake

The item that’s relatively clear in all this is the way to calculate the reward to risk ratio. We’ve done our best to build in some margin of safety to that ratio too. BUT we’ve still got to have better than a 25% chance of this thing turning around for it to be a rational bet.

How do you find that probability?

A Short-Cut To Buy The Dip Without A Looming Mistake

The looming mistake is that people forget to calculate that probability. There is no easy way to do it either (sorry). I have two reasons for thinking we have better than a 25% chance of a bounce.

One reason is technical. Look at the following chart.

I’ve tried to indicate what a swift decline looks like on the left. Interestingly, there was no major bounce with that decline–which is unusual. It did, however stop that trajectory and change to a slow decline for the next couple of months.

If you look at our current decline, we’re not going to follow that white line out indefinitely like that. Nothing just craters down into nothing with some bounces. It just doesn’t make sense. Even if we don’t get a bounce, I’d expect some slowing side-ways action like the May 2021 decline.

My second reason is macro-economic based. The present slide looks to have followed from an initial bill in India (banning a lot of crypto holding) and was then compounded by the Omicron strain of COVID.

The S&P 500 and cryptos are now rather strongly correlated, so we can get a better sense of how large institutional investors are thinking if we look at the futures market in stocks. A quick check on the contango ratio of the VIX (yes, all very complex to explain, but just go with me for a second) and you get this.

Ignore everything but the circled number. Generally, if that is above five, then the US stock market is highly optimistic. It’s well above 5%.

So, stock investors think the worst is over. Given the high correlation between stocks and cryptos, I’d take this as an indication that the worst might be over.

How strong is our percentage that this bet turns out? I’m not sure. But I do feel comfortable that it’s better than 25% likely to bounce = this is a rational trade.

Concluding Thoughts

Those are the 3 steps to making a rational bounce trade explained along with one looming mistake–and how to avoid it.

At the end of an analysis like this, you should feel a bit of trepidation. You’ll know the real odds that you’re facing and their possible rewards. Taking bets like this, though, in a consistent way is how you make money long term. It’s also how you out perform the benchmark (beat the market).

Of course, I let my paid subscribers know my thoughts–especially my trades–on topics like this rather directly. Yet I think this helps everyone understand a little better what’s going on with the strategy that I use.

This week I wrote a number of pieces that are related to this post, so you might want to have a look if you’ve missed them.

That’s it for this week. Remember to join us on Discord if you haven’t already.

Happy Trading!!

Disclaimers

General financial disclaimer: This post is provided for entertainment purposes only. I am not giving you financial advice and I am not a financial advisor. You should expect no financial returns one way or another based on my statements. These points hold equally for any statements that could be attributed to The Art of The Bubble or any related business entities. If you decide to buy or invest in anything, then your returns and potential losses are your own. No statements about taxation are taxable advice and you are encouraged to consult your own tax professional. You are also encouraged to do your own due diligence before investing in anything.