The importance of DCA strategy during a market correction
When considering cryptocurrencies as a medium to long-term investment, many investors face the problem of choosing a suitable investment strategy. Each investor is different in their time horizon, risk profile, and capital. However, for most investors, there is one strategy that is almost always of use.
Instead of making one single purchase using large amounts of capital, it is arguably better to buy digital assets gradually and build up a position over time. This type of investing strategy is called Dollar Cost Averaging (DCA). In today’s article, we will talk about how this approach is beneficial in terms of a risk management standpoint, and take a look at the ways of applying this strategy in the cryptocurrency market.
The cryptocurrency market, due to its nascency and innovativeness, is unstable and prone to sharp price fluctuations. A clear example of this was in May 2021, when the market dropped more than 50% from its all-time high, which resulted in the liquidation of many short-term investors’ positions. It’s worth noting that for investors following a DCA strategy, periods of market declines are the best time to increase holding positions. By initially choosing a price averaging strategy, users have available funds to buy at lower prices instead of buying the asset in one payment before the market decline.
Cost averaging requires investing a set amount of capital at regular time intervals, regardless of the market price. This reduces portfolio volatility, as the entry point is averaged by regular purchases of the asset across time, regardless of price.
The cryptocurrency market is unpredictable, so there is no way to accurately foresee future price movements and predetermine the best entry point. The DCA strategy allows you to take into account the impact of sharp price changes, where each subsequent entry into a position can be made at a lower price.
The basic principle of trading is selling an asset at a higher price than it was purchased. The problem is that it is impossible to reliably determine whether a given price is optimal in relation to the future price of the same asset. A DCA strategy allows you to soften the impact of short-term price fluctuations on the future value of your investment.
It is important to consider the number of open positions in your portfolio depending on the time scale and the amount of funds to be invested. For example, if you wish to purchase $10,000 worth of an asset to hold it for five years, you can divide your capital into equal portions and execute purchases weekly or monthly throughout a six-month period.
The principle of DCA is that the purchase of an asset over time will bring more effective results than buying it in a single payment. Thus it is possible to reduce the risks caused by market volatility.
It is vital to highlight the fact that this averaging strategy is not risk-free. An investor still must determine the time range for entering the position and set the exit targets.
It is also necessary to take into account the asset in which to invest. Taking Bitcoin as an example, applying a DCA strategy, in this case, has proven to be extremely profitable. Bitcoin is an asset whose price is constantly increasing in the long term. In this case, you can invest a set amount every month over the course of one or multiple years, expecting it to grow over the course of 10-years or more. Similarly, in an effort to capitalize on Bitcoin’s volatility, one can use DCA to buy coins daily for a month, expecting the price to rise over a six-month period.
To a certain extent, dollar-cost averaging resembles the HODL strategy, with the difference that the latter involves accumulating an asset and holding it, while DCA is inherently dependent on target levels. It is also worth noting that DCA is used not only for investments but also in both manual trading and automated trading with bots.
A DCA calculator was created based on historical Bitcoin data. The service offers a calculation of the value of a crypto portfolio using the principle of dollar-cost averaging based on the data entered: purchase amount, time horizon and frequency of purchases.
As an example, investing $100 every month for the past five years would turn $6,000 into $125,000 at the current price of Bitcoin.
If one considers the DCA strategy for investing in riskier assets, the success of this approach becomes questionable. Based on the huge number of new projects, many of which are likely to lose value over time, the strategy of buying such assets to hold for extended periods will result in portfolio losses.
When forming a strategy, it is worth considering market corrections, trends, and asset types. For example, in a bull market, the use of DCA can be unprofitable since each successive purchase will be at a higher price than the previous one. An averaging strategy is best used in an uncertain market; in case of high confidence in future price growth, a one-time trade will be a more beneficial solution.
DCA bots by 3Commas
The DCA strategy is available for automated trading with 3Commas bots and provides effective trades for a set period of time. Using averaging and automating short-term trades has a number of advantages:
- When the price falls below the initial buy level, another position is opened, thereby averaging the position down.
- The use of “Take Profit”, which moves along with the average price, increases your chances of profiting from your position, even if the initial buy price is not reached again.
- Flexible settings to use the trading strategy in any market conditions.
Read more about DCA bots and other automated trading tools on the 3Commas blog.
A successful application of DCA depends on knowledge and understanding of the market. If used correctly, this strategy can reduce the risks of losses while increasing profit potential along the way. However, don’t forget to take into account the risks of investing in cryptocurrencies and your own expected target profits. It’s worth remembering that the successful application of DCA depends on numerous factors. For this reason, it’s best to make your own calculations based on your investing goals before getting started.