Nothing beats buying once and HODLing on for dear life, but where's the fun in that? Besides, to effectively HODL, one’s initial capital has to be large enough to make one trade profitable to forget about.
But we're in an industry with more Shrimps than there are Sharks, essentially why active trading is the only way for the average player to build wealth overtime.
But trading is a psychological warfare, most people lose the game before even starting because they are prone to give in to emotions — the core enemy of a winning strategy.
To solve this problem, we need a little bit of automation and a bit of math knowledge plus a tiny bit of insights into market circles.
Make no mistake, we are not bulletproof, but if the devil has bigger fishes whose lives he has to f*** over, we could do just fine, if we stick to the math.
First, the basics; What's DCA Trading?
DCA stands for Dollar-Cost Averaging and it is a trading/investment strategy that involves dividing the total amount or capital one wishes to invest in an asset into smaller, equal portions and investing those portions at regular intervals, often regardless of the asset's price.
For instance, say you want to dump $1,000 into Bitcoin using DCA: Instead of investing the full $1,000 at once, you could invest $100 every week for 10 weeks.
When prices are high, your $100 typically afford fewer units; whilst when prices are low, it buys more, averaging out the cost over time.
What's AMM DEXs?
AMM DEXs (Automated Market Maker Decentralized Exchanges) are a type of decentralized exchange that uses mathematical algorithms and liquidity pools to enable users to trade cryptocurrencies directly from their wallets without the need for a traditional order book or a centralized intermediary.
Instead of matching buyers and sellers, AMMs rely on liquidity pools, which are collections of two tokens (e.g., ETH and USDT) supplied by liquidity providers (LPs). — ChatGPT
Traditional order books are what you have on Spot markets where you set a price, input amount and initiate your buy or sell order. With order books, there has to be an opposing order that matches your set prices for the trade to go through, otherwise, it will remain pending until a trader fills it.
With AMM DEXs, orders are executed immediately because trades are filled using the liquidity provided by users or investors chasing yield in the pools.
Now, most liquidity pools are made of token pairs 50/50. For instance, A ETH/USDC AMM pool set to 50/50 will require liquidity providers to have equal value amounts of both tokens to be able to add liquidity to the pool.
The benefits for users or investors is that they get to earn a fee share paid by traders and sometimes secondary platform tokens. It is important to note that AMM with varying pairs ratio exist, meaning that a pool could be set to 80/20, this is available on Balancer and it allows one manage exposure to a specific token, holding less or more liquidity in it, depending on if they are long-term bullish or bearish on the asset.
What Makes AMMs DCA Goldmines
Short answer: impermanent losses
The first time I provided liquidity to a pool I lost money. This was because I did not understand how it works.
One of the biggest risks associated with liquidity provision to AMM DEXs is impermanent losses but it's also the biggest goldmine for those who understand it.
Impermanent loss occurs when the value of your liquidity pool (LP) tokens changes due to market price shifts of the pooled assets. It is "impermanent" because the loss only materializes if you withdraw liquidity before the prices revert.
Now, you're probably wondering why a market price shift should cause a loss in your position value. Well, that happens because the AMM dex is designed to always maintain the set ratio for overall pool value.
This means that if a pool ratio is 50/50, irrespective of the direction the market moves, the pool has to adjust itself by selling either token to ensure the balance in value is maintained.
In the process, a specific token from the pair is bound to decrease while the other increases, which essentially affects your position holdings and value as your percentage share drops to levels that tallies with the change in the pool’s overall value, not just in market sum but also in sum of total assets held.
The good thing with this design, that most newbies miss, is that it's a goldmine for automating DCA trading while earning fees.
First off, this is effective for dual-direction trading. Meaning that it'd work regardless of if you're after DCAing out of a your position in a specific asset or DCAing into a larger position.
To maintain a healthy position, you have to watch two things; your percentage share of the pool and fees earned(essentially pool APR).
When you're working with pools with a sustainable yield structure, you can effectively offset the loss difference between being a liquidity provider or just holding a specific asset. It also would potentially leave you with extra funds to rebalance your position in cases where the pool’s liquidity increases.
Speaking of liquidity, your share of the pool directly influences how much assets you can acquire via impermanent loss adjustment or how many you can sell autonomously as prices increase.
Generally, this is not a problem when you first join the pool, but it becomes an issue after the pool liquidity increases significantly from the initial level at your entry.
Moving on.
To the average guy, the USD value of their holdings is what matters to them. So when they look at changes in a liquidity pool, all they see is how much they've lost to impermanent loss adjustments as prices rise or fall.
In a scenario where prices increases, especially in a pool where a volatile asset like ETH is paired to a stablecoin like USDC, when the price of ETH increases, all the average trader can think about is how their holding is now worth x value, but when they jump to withdraw their liquidity, they find out that they have less ETH and more USDC, and the combined value isn't up to the current market value of both assets if they could have simply held their tokens in a non-custodial wallet.
In a scenario where the price of ETH falls, the average guy looks to withdraw liquidity, usually to make use of the stablecoin, only to realise that the stablecoin has been used to purchase more ETH and now they have less USDC to work with.
The smart traders, however, see the DCA opportunity staring right back at them.
Price falls? The smart contract autonomously buys more ETH.
Price rises? The smart contract sells more ETH into stables.
Depending on the individual's timing of market circles, an AMM DEX becomes a literal non-centralized trading bot to slowly grow one's holdings of a specific asset or slowly sell off as the market grows.
All of this while earning additional fees.
Essentially, a trader is autonomously longer and shorting the market at the same time, so unless they don't have long-term skin in the game, this is a goldmine to grow one's wealth without subjecting oneself to the emotional turmoil of manual trading.
To round up, traders have to watch the rate at which liquidity grows as that affects their percentage share of not just fees but pool allocation as impermanent loss adjustments occur overtime.
You can calculate your potential returns using the impermanent loss calculator on Coingecko, note that values may not always be accurate so search Google for alternative calculators for comparison.
Smart contracts exploitation remains a significant risk factor to DeFi protocols, only use services you trust.
This article is for informational purposes only and not financial advice. DYOR