The ability to identify letters and encode their position is a crucial step of the word recognition process. However and despite their word identification problem, the ability of dyslexic children to encode letter identity and letter-position within strings was not systematically investigated. This study aimed at filling this gap and further explored how letter identity and letter-position encoding is modulated by letter context in developmental dyslexia. For this purpose, a letter-string comparison task was administered to French dyslexic children and two chronological age (CA) and reading age (RA)-matched control groups. Children had to judge whether two successively and briefly presented four-letter strings were identical or different. Letter-position and letter identity were manipulated through the transposition (e.g., RTGM vs. RMGT) or substitution of two letters (e.g., TSHF vs. TGHD). Non-words, pseudo-words, and words were used as stimuli to investigate sub-lexical and lexical effects on letter encoding. Dyslexic children showed both substitution and transposition detection problems relative to CA-controls. A substitution advantage over transpositions was only found for words in dyslexic children whereas it extended to pseudo-words in RA-controls and to all type of items in CA-controls. Letters were better identified in the dyslexic group when belonging to orthographically familiar strings. Letter-position encoding was very impaired in dyslexic children who did not show any word context effect in contrast to CA-controls. Overall, the current findings point to a strong letter identity and letter-position encoding disorder in developmental dyslexia.