Many traders are interested to minimize their risks in trading. One of the major problems is to estimate when the price of an asset has reached its bottom. There is always the possibility involved that the price didn’t found support yet and is going down further.
Dollar-cost average or DCA is a strategy to tackle this very common problem in trading. It is a method to mitigate the fact that you cannot be right all the time.
Using support levels
There are two types of DCA strategies. The first one will focus on historical support levels. Meaning that traders usually place buy orders at each level, while each order represents a fixed percentage of the trader’s respective portfolio value.
Let’s say he would like to invest €1000, but he is not sure where the price will bottom out. He identifies 6 possible support zones and therefore decides to place 6 different orders placing them at each of the support levels.
He might choose equal amounts, meaning each order is worth around €167. Alternatively, he might choose to spend different positions sizes on each order, depending on his assessment of the possibility that the price will hit each low.
Ignoring support levels
The second method relies simply on buying at different points in time. This is a very common strategy favoured by beginners because it doesn’t exactly need any type of analysis. A trader might choose an arbitrary date when he buys, e.g. at the beginning of each month or each week.
At each point in time, he will most certainly buy at a different price level. Meaning that he increases his position over time. Most traders choose even position sizes each time they buy, but they might as well opt for uneven sizes.
What is the benefit of DCA?
In the first example, the average entry price is lowered each time the trader buys. However, in the second example, the trader risks buying not at support levels, but at random points in time, meaning that his average price could be higher.
In the end, both methods will help traders to average their costs when building a position instead of placing one order and risking that the price will go down from where they bought. This is especially useful with cryptocurrencies since they are considered a highly volatile asset class.
Please note that this strategy also depends on how each position is managed. Meaning that there is still the possibility involved that the price might go lower and the trader risks to run out of money. In order to face this issue, one is well advised to choose the right size for each position and not spend all of his money too early.
The same method comes in handy if one like to sell or reduce a position that is in profit. There is always the opportunity that the price will go higher. Therefore, a trader might choose to sell partials of his position at resistance levels or at arbitrary points in time.