What is Dollar-Cost Averaging? A Beginner’s Guide

Introduction

Blockchain and cryptocurrencies have played an important role in involving more people in financial management. Therefore, more people have started to take an interest in trading despite having no formal training for investing.

Several researchers have conducted experiments teaching trading to grade school students showing good results. It proves that just about anyone can learn to trade successfully with little training. In the world of Chinese philosophers and educators:

What is a Trading Strategy?

A trading strategy is a qualified and formal method for performing the trading process. Since most people do not get any type of financial education in their schools, they grow up not able to manage their financial matters.

Therefore, most people see cryptocurrencies and stock trading as gambling or a sure way to lose their savings despite facing financial troubles. However, professional traders can make profits from investment options because they make their trading decisions based on tried and tested trading strategies.

When investors learn trading strategies, they can start reading the market just like trading professionals and be able to make rewarding trading decisions rather than treating trading like a betting ring.

Types of Trading Strategies

Trading is a complete profession and a job. It is not a matter of luck as much as it is about doing the work and collecting useful information from the trading markets. Trading is neither as difficult nor as easy as most people assume. There are many facets to trading that every trader should take into consideration before investing their savings. Here are some of the most common types of trading strategies based on different trading factors:

Based on Trading Strategies

Momentum Trading

Momentum Trading is a type of trading technique that allows investors to place, sell or purchase trading assets based on their recent price trends. Momentum traders take a look at the investment options that the investors try to identify stocks with high percentage returns and considerable volume movement for a given trading period. It entails making trading decisions when the trading assets are visibly trading in one direction, either bullish or bearish.

Momentum traders make profits by selling stocks when markets are in an uptrend and buying them when the market is down-trending.

Mean Reversion

Using Mean Reversions, investors base their trading decisions on reading the historical price means for a trading option. In this manner, the investors can create either long or short positions by identifying trend reversal signs.

The mean reversion technique entails that when there is a fluctuation in the mean price movement for an asset, it usually reverts to the previous trend based on its mean value. It can also be seen as the polar opposite of momentum trading, where investors are looking for a strong trend continuation, whereas mean reversion enables the investors to find signs of trend reversals to generate profits.

In momentum trading, investors try to buy high and sell higher during an uptrend while selling low and buying lower for a confirmed downtrend. However, mean reversion traders stick to sell low and buy high approach for long or short positions.

Based on Time-frame

Scalping

Scalping is a trading technique where investors try to scrap profits by exploiting bid-ask spread. By doing so, investors are hoping to create a high frequency of small profit scalping by opting in and out of new trading positions many times within 24 hours.

Day Trading

Day Traders depend on technical analysis to identify the most volatile trading assets. Therefore, they opt to purchase and sell trading positions within 24 hours. The trading position for a Day trader can last from a few hours to a whole day. Day traders are in the same line as turtle traders and scalpers.

They wish to capitalize on high frequency and small profit percentages. At the same time, they are also able to use volatile and risky assets such as cryptocurrencies to their advantage. All short-term trading period techniques also use leveraged positions to increase their trading capital; however, it can increase their trading risks significantly.

Swing Trading

Swing Trading is another short-term trading technique. However, this type of trading requires hunting for the most liquid assets and making profits by exploiting their volatile prices. These assets must be reverting to their median prices or present in a fading trend.

The duration of swing trading is medium-term that can last for a day, a few days, or up to a few weeks.

Positional Trading

Positional Trading is another type of medium-term trading technique that lasts longer than swing trading. Traditionally, positional trading duration lasts from a few weeks to a few months, and sometimes it can span a whole year.

The probability of success for positional traders is higher, considering that in most long-term trading periods, the market tends to move upward.

Based on Technical Analysis

Technical Analytics

Technical Trading is based on charts and graphs reading and collecting on-chain data about the performance of an asset. There are several technical indicators that investors can use to find out different aspects and trading behaviors that control the price movement of an asset.

Technical analysis is one of the most controlled and warranted ways of trading because it can generate highly probable projections based on current and past trading patterns. However, the technical analysis only looks at the price action.

Fundamental Analytics

Fundamental analysis is a type of trading option where the investors take a look at the market factors and economic forces. It is a macro-level analysis method that consists of looking at factors such as earning reports, stock divisions, company structure, acquisition, and other important changes.

Fundamental analysis is ideal for long-term trading styles that can warrant the safety and consistent performance of stocks.

Techno-fundamental Analytics

The techno-fundamental analysis is a merger of both of the aforementioned analytics. Using this trading technique, investors can get the best of both worlds by reading the changes in the price movements using technical analysis.

On the other hand, they can also take into consideration macro trading factors such as company changes, economic derivatives, and legislative requirements. Using techno-fundamental analytics, investors can shortlist the best stocks for long-term investing and work out the best entry/exit positions at the same time.

Based on Trading Products

Equity Trading

Equities or stocks are arrears that are issued by a company after it decides to get a public listing. Companies or governments can issue stocks with collecting funds for capital investments or operational expansion. In return for stocks, the investors are promised a share in the ownership of the organization and also qualify for a profit share.

At the same time, some stocks also issue dividend income for their equity holders. Investors can purchase these stocks from stock exchange markets or over-the-counter platforms.

Derivatives Trading

Derivatives are purchase or sell contracts for stocks that track the performance of an underlying asset. Derivatives allow investors to take advantage of the movements of stock without acquiring it directly. Investors can create put or call options for the derivatives based on the future price projection for its underlying asset.

Derivative trading is considered riskier, and the two most common types of derivatives are futures and options.

Forex Trading

Forex Trading uses the arbitrage technique to make profits. In this type of trading option, the consumer trade one legal tender with another fiat currency and makes profits based on the exchange differences.

There are also cases where the forex traders can make profits by purchasing one legal tender for a smaller price using one market source and selling it for a higher price on another platform for a higher return.

Sometimes, people also purchase and store forex reserves and sell them when their prices increase in the market concerning the period.

Commodity Trading

Commodity trading is one of the earliest types of trading. It allows the investors to generate profits using sell and purchase of metals such as gold, energy-producing goods such as crude oil, crops such as coffee and wheat, and livestock such as meat or feeder cattle, etc.

Most countries have dedicated financial regulators for commodity trading, such as the Commodity and Futures Trading Commission in the USA.

Cryptocurrency Trading

Blockchain or Defi platforms issue cryptocurrencies that are the digital contemporaries of fiat currencies. However, most people have started to use cryptocurrencies as a hedge against inflation. Some of the most common types of cryptocurrencies are coins, tokens, stablecoins, NFTs, and crypto derivatives.

Based on Investment Capital

Lump-sum Trading

Lump-sum Trading refers to the type of trading where the investors utilize their whole trading capital in one go to create a new trading position. It means that the investors can create a new trading strategy and read the market using technical and fundamental analysis.

When they have identified the movements of the market and have decided their trading period, they can invest the whole trading capital into one go to create a long or short position.

Value Averaging Trading

The value averaging method is where the investors increase their trading positions when the markets are down and decrease when markets are bullish. With value trading, investors predetermine the total value levels using calculations for the future and make an additional investment when these projections come true.

Rather than investing based on the passage of time, VA investors increase their trading positions based on relative portfolio sizes.

Range Trading

Range trading is a technique where investors increase or decrease their trading reserves based on a decided price range. For example, if an investor has identified the range of $10-$15 for an asset, they are going to conduct range trading for weeks using the same range.

In this way, the investor will purchase more assets whenever the prices reach $10 and sell these assets when the prices rise to $15 again. The range trade session continues until the price range is intact for the said asset.

Dollar-Cost Averaging

Dollar-Cost Averaging, or DCA, is when the investors set aside a set amount of investment reserve for a specified asset. The investors then decided on a time interval that allowed them to increment their investing position at regular intervals. It means that the investors do not use all their trading reserves at once, just like lump-sum trading.

On the contrary, they invest their capital with regular intervals that grant them greater control of their investment, and they can also condition the increment of investment based on the performance and market fundamentals.

What Is Dollar-Cost Averaging?

Dollar-cost averaging is a long-term investment strategy that warrants a safer injection of investment capital into the market at regular intervals. With DCA, the investors do not take the risk of pouring all their investment capital into a new trading position at once.

On the contrary, the investors set aside the investment capital and utilize it for accumulation at regular intervals after the passage of a specified trading period.

Dollar-cost averaging prevents the investors from going all in at once to acquire a long or short position for a targeted asset class. Instead, it grants the liberty to the investors to appreciate their trading positions gradually while keeping an eye on the market movements.

Dollar-cost averaging smooths out the average cost of the asset due to the fixed dollar purchase simultaneously. This method is also known for getting an endorsement from Warrant Buffet, who nominated it as a good trading technique for investors with little time for formulating expert trading techniques.

How does Dollar-Cost Averaging Work?

Dollar-cost averaging allows investors to nominate a set amount of trading capital for purchasing or shorting a specified asset. Rather than using all of the investment capital at once to create a new trading position, the investors spread out their purchases at regular intervals.

The investors have the option to set a defined price condition to increment their trading position. In the same manner, the investors also divide their total investment capital into equal parts to advance at regular intervals when the predetermined market conditions are met.

DCA flattens the average cost of accumulation for an asset and decreases the loss probability on account of trading inefficiencies. DCA can be explained in the following simple steps:

Comparative Analysis of Dollar-cost Averaging Trading

Investors can learn more about this trading strategy by pitting it against different market scenarios. Based on the market factors and comparative analysis, here are four scenarios of Dollar-cost averaging trading:

Lump-sum Purchase

This is the first scenario where the investor has decided to invest a capital of $10,000 on a lump-sum basis. The investor has decided to accumulate XYZ coins at a purchase price of $50 each. That means that they are going to accumulate 200 shares.

Bear Markets

Now, it has been established what percent of returns the lump-sum accumulation can generate. Here is the second scenario that takes place in a bear market where the investors have decided to use DCA and split their $10,000 investment capital into four parts, namely $50, $40, $30, and $25. The trade commences for 12 months, and the trader can make four $2,500 purchases acquiring 295.8 shares. The amount of total share accumulation is already greater than the lump-sum method.

Breakeven Market

The third scenario is set in the market when the price movement is persisting in sideways. Therefore, the market is mostly stable and stagnant. In this scenario, the trader once again put their $10,000 into use by splitting it into four sets of $2,500.

The investor is going to accumulate ABCD shares whenever it reaches $50, $40, $60, and $55 price points. The trading session continues for a whole year.

In this situation, the investors have accounted for both minor ups and downs of the asset in question. Investors are often unable to predict the direction of an asset with perfect accuracy. Therefore, using the DCA method, investors can take advantage of the market by purchasing at lower prices, and they can maintain profits even at higher prices. Furthermore, they can get higher profits if the asset price goes lower than before by way of purchasing dip.

Bull Market

The fourth scenario is an uptrend market where the prices of an asset are incrementing. The investor splits the $10,000 capital into four parts and assigns it to purchase at $50, $65, $70, and $80. In this manner, the investors would be able to accumulate around 155.4 shares.

Using the above four scenarios, the reader will now be able to understand the application and successful usage of the Dollar-cost Averaging method properly.

Conclusion

Dollar-cost averaging is a useful trading technique that investors can use to their advantage. By learning about the advantages and risks associated with this trading method, investors can make the most out of their trading positions. At the same time, it is important to apply this trading technique in the context where it can generate the maximum output for the investors.

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