Within the realm of active currency trading, there are numerous strategies. Each has a collection of necessary inputs, defined rules and objectives. From forex day trading to long-term investment, there's a style for everyone. For those with a limited risk tolerance, a scalping strategy may be a viable means by which to profit.
Legions of forex traders choose the scalping trading strategy as their primary means of conducting business. But what is scalping? In this article, we will address the strategy and take a deep dive into how successful forex scalpers make a living in the world's currency marketplace.
What Is Forex Scalping?
According to the U.S. Commodity Futures Trading Commission (CFTC), a scalper is: "A speculator who buys and sells rapidly, with small profits or losses, holding positions for only a short time during a trading session."
Currency scalping is not much different from the CFTC's definition. It is a forex trading strategy that aims to make small profits quickly and repeatedly in the live market. Essentially, scalping is predicated upon executing a significant number of trades each session in an attempt to benefit from small foreign exchange price movements.
The scalping trading style has a collection of objectives that makes it a unique way of approaching CFDs, shares and the forex market.
Scalpers are required to execute a large number of trades in order to sustain profitability. To do so, many focus on FX charts with small durations such as the one-minute chart to scrutinise micro price fluctuations in real-time.
Using such compressed time frames, it's not uncommon for an FX scalper to execute dozens of buys and sells each trading session.
Positive Risk Vs Reward
No matter how short the time frame may be, the forex scalping strategy aspires to have a long-term positive expectation. Accordingly, risk and reward must be aligned to produce profits over time. This means that although profit targets may only be a few pips, each trade's stop loss is equally tight. In this way, forex traders can buy and sell currencies on a reduced scale while maintaining viable risk vs reward ratios.
Perhaps the single greatest calling card of the scalping trading strategy are short trade durations. Scalpers aim to enter and exit positions as quickly as possible to minimise their exposure to broader systemic risk.
Systemic risk is defined as the chance of an entire market collapse occurring. Scalpers view a reduction of systemic risk as being a key element of the strategy's aggressive risk management framework.
1. The Breakout Strategy
A breakout is a sudden, significant, directional move in price. It can arise from fundamental or technical factors and may provide exceedingly profitable trading opportunities.
In most cases, a market break is preceded by a period of rotational or compressed price action. When the compression reaches critical mass or "breaking out," price moves considerably to the bull or bear. During the rapid price action, scalpers attempt to harness the enhanced volatility and realise profits.
Scalpers trade breakouts in many ways. One of the most common is to use technical tools such as Japanese candlestick chart patterns or a volatility measure such as Bollinger Bands (BBs). By doing so, the scalper may spot periods of market consolidation and potential breakouts before they occur.
The following scenario is an example of a breakout. Assume that the AUD/USD has traded in a tight consolidation pattern on a 30-minute time frame. As a result, Sam the scalper has decided that a bullish or bearish breakout may be in the offing.
Analytically, Sam implements BBs to address market volatility. During periods of consolidation, the upper and lower BBs tighten; amid trending markets, they widen. As a general rule, tight BBs suggest that a breakout may be imminent.
Sam decides to trade the AUD/USD 30-minute chart, which is in heavy rotation. Rates are near flat, causing the BBs to narrow. Price has repeatedly tested and rejected the upper BB at 0.7400. Sam believes that a bullish breakout is pending above this level and decides on the following scalp:
- A buy order is placed at 0.7401.
- A stop loss is placed at 0.7394.
- A profit target is placed at 0.7408 according to a 1:1 risk vs. reward ratio.
If the bullish break above 0.7400 is successful, Sam will realise a quick 7 pip profit. Given the short time frame, minimal profit target and stop loss, the effectiveness of this breakout trade relies on tight spreads and low slippage.
2. The Reversal Strategy
A market reversal occurs when a prevailing trend changes or "reverses" its present course. The result is the beginning of a new trend or retracement in price. Subsequently, a new short-term or long-term bottom or top forms.
Reversal trading is a challenging endeavour because accurately predicting a market's peak or valley is difficult. However, reversal scalping strategies do not aim to project highs and lows; they search for short-term pullbacks in price. In this way, scalpers can execute counter trend trades with limited risk exposure.
One way that scalpers approach reversals is by using momentum oscillators. A momentum oscillator measures the velocity of price action. As price action slows or becomes exhausted, a reversal occurring becomes more probable. Examples of this variety of scalping indicators are the Stochastic oscillator and the Relative Strength Index (RSI).
Legions of forex day traders and swing traders focus on trading reversals. Also, many trading systems are designed to engage the same market conditions, only with much smaller risk and reward parameters.
Let's say that Riley is a reversal scalper who is evaluating a strong uptrend in the EUR/USD. The price action on the 5-minute chart is decisively bullish, with rates rising more than 75 pips in a four candlestick range. Price is pushing intrasession highs just beneath the 1.1000 level.
Riley is using RSI to quantify short-term price exhaustion and decipher a potential selling opportunity. Currently, the RSI is reading 90, which signals that the EUR/USD is overbought at 1.0994. Here's how Riley plans to scalp a pending reversal:
- A sell limit order is entered at 1.0996.
- A stop loss is placed at 1.1004.
- A profit target is located at 1.0988 according to a 1:1 risk vs reward ratio.
One of the benefits of counter trend scalping is that one does not need to be correct about the market's future direction. All price needs to do for Riley to realise a profit is momentarily pullback from the vicinity of 1.1000. If so, the account balance grows and future price action has no impact on Riley's P&L.
3. The Reversion To The Mean Strategy
A reversion to the mean, or simply "reversion," is a strategy designed for rotational markets. In rotational market conditions, price moves within an established range. This range may be the product of factors such as low participation or the presence of support and resistance levels.
To trade a reversion strategy, one sells the upper extreme of an established range and buys the lower extreme. Profit targets are located near the middle or "mean" value of the range. An exponential moving average (EMA) is one technical indicator that may be used to help ballpark the centre of such trading ranges.
From a scalping standpoint, reversion trading is one way to approach slow or stagnate markets. However, contrary to breakouts, the goal is to capitalise on a lack of momentum in price action.
To illustrate this type of strategy, let's assume that Riley has decided to take up reversion scalping. Riley thinks that the USD/CHF is a prime candidate; the 15 minute chart shows that price has been in heavy rotation as it has been constrained between 0.9300 and 0.9325 for the past several hours. Accordingly, Riley builds the following scalps to target the middle of this range:
- A sell order is placed at 0.9324, with a stop loss at 0.9332 and a profit target at 0.9316 (1:1 risk vs reward).
- A buy order is placed at 0.9301, with a stop loss at 0.9293 and a profit target at 0.9309 (1:1 risk vs reward).
Riley's reversion scalps will be profitable as long as the range holds. In the event the USD/CHF breaks out, the minimal stop losses will quickly limit the account drawdown.
Necessary Inputs For Scalping
The primary facets of any scalping system are high trading frequency, positive risk vs reward, and short trade durations. So, is forex scalping the best way to trade? Given the proper inputs, many professional traders certainly think so.
Aside from computing power and internet connectivity, scalpers must secure several key assets before entering the market. The services of a solid forex broker, liquidity, volatility, a robust trading platform and analytical base are required to scalp currency pairs successfully.
Choosing A Broker
One of the most critical decisions that a scalper must make is choosing a foreign exchange broker. A strong FX broker is reputable, reliable and in good legal standing. When selecting a brokerage outlet, it's important that the firm satisfies this basic criteria.
For the scalping method of trading, order execution is paramount. Scalpers need to have their orders routed, matched and filled as efficiently as possible. Thus, quality execution is fast and without slippage. In scalping, it's imperative that the broker offers premium order placement and execution.
Trading with high frequencies on a short-term time frame requires the trader to act with precision. Thus, the scalper needs to have a robust trading platform at their disposal.
The best forex platforms are intuitive, user-friendly and low latency. Latency is a term used to describe the period of time it takes data to flow to and from the market. A low-latency platform does not contribute to data lag or bottlenecks. It is glitch-free and promotes precision as data is transferred seamlessly to and from the market.
One way to test if a trading platform is up to the task is to trade a demo account. In doing so, you can get up to speed on the functionality and features of the platform.
The optimal market conditions for scalping forex trading strategies consist of two elements: liquidity and volatility. Here's a brief look at each:
- Volatility: Price changes and market fluctuations are necessary inputs for successful FX scalping. Although profit targets and stop losses are small, there must be at least some price action to produce viable scalping opportunities.
- Liquidity: Market depth is a key element of successful scalping. Strong participation and order flow ensures that bid/ask spreads are tight and slippage is minimal. For instance, major currency pairs such as the EUR/USD, GBP/USD, USD/JPY and USD/CAD are target-rich environments for scalpers.
Day traders, swing traders, long-term investors and scalpers all need some form of analysis to craft trading decisions. Unfortunately, many beginners neglect developing a strong analytical base before diving head first into the markets. This can hinder the trader's ability to identify opportunity and apply prudent risk management principles.
There are two basic types of analysis:
- Fundamental: Fundamental analysis is the study of how external factors impact market behaviour. Economic data, governmental policies, central bank actions and geopolitical upheaval are several fundamental factors that impact the forex. These elements can quickly sway exchange rates and drive markets directionally.
- Technical: Technical analysis is the study of price action itself. Market technicians scrutinise past and present price fluctuations in an attempt to project future market behaviour. To do so, technical indicators and tools are used to place evolving price action into a manageable context.
Both fundamental and technical analysis are used by active traders from London to New York. Typically, fundamentals are favoured by longer-term traders, while technical analysis is the go-to methodology for shorter-term, intraday, day, and swing traders.
Although there is no "correct answer" to the analytical question, technical analysis is often implemented in forex scalping strategies.
Scalping is a forex trading strategy designed to generate profits by executing a large number of trades. Scalps have short durations, limited risk and minimal profit targets. Market efficiency and trade precision are important as slippage and wide bid/ask spreads can undermine performance.
The top three forex scalping strategies are the breakout, reversal and reversion methodologies. If implemented consistently, each can produce positive returns over the long-run. Ultimately, it's up to the individual to decide if scalping is a suitable way to trade the forex.
Please note that all examples are only shown for the purpose of demonstration and should not in any way be construed as recommending any type of trading strategy and they do not constitute any form of investment advice.
FXCM Research Team
FXCM Research Team consists of a number of FXCM's Market and Product Specialists.
Articles published by FXCM Research Team generally have numerous contributors and aim to provide general Educational and Informative content on Market News and Products.
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