In the financial marketplaces of the world, there are numerous different styles and trading methodologies employed with the goal of achieving profitability. One of the most prominent forms of trading used by both retail and institutional traders alike is known as "scalping." Scalping is a trade management strategy in which the trader elects to take small profits quickly as they become available within the marketplace.
Often referred to as "picking up pennies in front of a steam roller", scalping focuses on identifying fluctuations in price during the extreme short-term. Essentially, this trading philosophy is based on the idea that taking small profits repeatedly limits risk and creates an advantage for the trader.
The viability of scalping as a trading approach depends on several contributing factors and inputs:
- Low transaction costs: Commissions and fees need to be minimised in order to facilitate a high-volume approach to trading in a given financial market.
- Efficient market entry and exit: Adequate computer hardware and software technology is required to minimise latency-related slippage and interact within the marketplace efficiently. Slippage on entry and exit can play a major role in the overall profitability of a scalping approach and is magnified when the realised profit per trade is small.
- High volume trade identification: A major part of the scalping methodology is to repeat small profits over and over. It is crucial that the adopted trade recognition philosophy is able to produce a high volume of possible trades.
- High market liquidity: The ability to enter and exit the market quickly and efficiently is dependent upon the number of potential buyers and sellers available at the trader's desired price. Markets that exhibit a high degree of liquidity, in addition to tight bid/ask spreads, are prime candidates for scalping.
There are several common methods of scalping in which short-term traders attempt to secure market share. Strategies aimed at capturing the bid/ask spread are prevalent in forex scalping, while increased leverage with the objective of harvesting minute moves in price are commonplace in the futures and equities markets.
Advantages Of Scalping
Perhaps the single largest advantage attributed to a trading approach based on scalping methodology is the limited market exposure afforded to the trader. At its core, scalping is an ultra-short-term trading strategy; therefore, the trader (and the equity in the trading account) is only vulnerable to short-term market volatilities. Typically, the short trade durations insulate the trader from greater systemic risks present in the marketplace, and limit the potential liability of each trade.
Another upside is the ability for a trader to profit from rotational or slow markets. While it is true that the most liquid and volatile markets are the primary target of many scalping operations, trading with the goal of capitalising on small market moves can prove to be profitable in stationary markets.
Often, trend or momentum-based trading methodologies struggle when faced with markets stuck in a consolidation or rotational phase. In these market states, fluctuations in price are limited, with the movements in price itself not being robust enough to reach required profit targets. Scalping eliminates the need for a directional market move to realise a profit, because small fluctuations in price are enough to achieve profitability and sustain a scalping approach.
Disadvantages To Scalping
Drawbacks to employing a trading approach based on scalping are numerous and closely related to trader discipline and psychology.
The very nature of scalping is to take small profits quickly in order to limit risk and create a consistent flow of revenue. However, in the pursuit of small profits, the scalper foregoes potentially lucrative trending markets in addition to large and directional pricing moves. In turn, it is possible for a trader to repeatedly "miss out" on trends and generous profits while adhering to the scalping trading plan. Over time, the fear of missing out on these moves can test trader discipline, lead to overtrading, and take a psychological toll on the trader thereby inhibiting performance.
Another drawback to employing a scalping approach is the increased use of leverage. To realise an acceptable profit on a given trade, scalpers often employ large amounts of leverage to boost profit. Trading for small numbers of ticks, pips or points often goes hand in hand with adding several contracts, lots or shares to the trade. Leverage acts as a double-edged sword. In the event a trade is not an immediate success, the potential liability is increased exponentially.
Scalping In The Live Market
Like in any other trading methodology, spotting positive-expectation opportunities is a primary aspect of scalping successfully. And, given the "instant gratification" philosophy of most scalpers, it's imperative that only the best trade setups are acted upon. If not, profits quickly dwindle as slippage and misaligned risk to reward payoffs compromise the trading operation's bottom line.
To optimise performance in the live market, developing a strong strategic foundation is of paramount importance. Focussing on ideal markets, sound analytics and the proper order types are essential components of building a comprehensive scalping strategy.
Choosing An Ideal Market
As covered earlier, a viable scalping market must feature both consistent volatility and depth. These characteristics promote efficiency as they ensure a multitude of trading opportunities and largely-beneficial order fills.
Scalping strategies are not limited only to forex currency pairs; they are also frequently employed on futures, cryptocurrency and equities products. With liquidity and volatility in mind, below are a few of the premier offerings from each security classification:
- Forex: On the forex, the major currency pairings are suitable targets for scalping. Specifically, the EUR/USD and GBP/USD offer consistent opportunities.
- Futures: Listed on the Chicago Mercantile Exchange (CME), equity index and commodity futures are renowned scalping markets. Leading products include the E-mini S&P 500, West Texas Intermediate (WTI) crude oil, and gold.
- Equities: Shares of large, liquid companies such as Apple (AAPL), Boeing (BA) or Facebook (FB) are examples of scalp-friendly stocks. Additionally, equities-based exchange traded funds (ETF) also draw significant attention.
- Cryptocurrency: The digital currencies Bitcoin, Ethereum and Ripple are exceedingly popular in scalping circles.
The instruments listed above offer the liquidity and order flow conducive to profitable scalping. Although the underpinnings of these forex, futures, equity, and cryptocurrency products are unique, adequate market depth and volatility are typically present.
Scalping strategies come in a wide variety of forms, and they range from simple to ultra-complex. However, no matter the governing parameters, all scalping strategies are designed to repeatedly take small profits from the market. This involves the implementation of tight stop losses, modest profit targets and compressed time horizons. Otherwise, the trade is not a true scalp.
Identifying positive expectation trade setups is the crux of any viable trading strategy. Accordingly, an analytical base is needed to place evolving price action into a useful context. For scalping strategies, analytics may be classified in one of three ways:
- Fundamental: Although typically used in longer-term trend following or reversal strategies, fundamental analysis may be applied to scalping strategies as well. Among other tactics, scalpers utilise fundamentals by analysing the impact of a scheduled economic data release or surprise event on market participation rates (liquidity, volatility).
- Technical: Technical analysis is the most popular device integrated into scalping strategies. Indicators and tools are readily applied to price action itself, providing concrete market entry and exit points.
- Hybrid: Hybrid analytics combine elements of both fundamental and technical analysis. An example of hybrid analysis would be to use fundamentals to identify optimal scalping conditions before implementing technicals to fine-tune market entry/exit.
Finding solid opportunities in the live market is not a simple task. Nonetheless, through the application of fundamental, technical, or hybrid analysis, one is able to determine when conditions are suitable for successful scalping.
After finding a viable product and strategy, it's time to secure marketshare. This involves entering and exiting the market with precision while reducing trade-related slippage as much as possible. To accomplish this goal, employing the proper order types is a key aspect of conducting day-to-day business.
In contrast to longer-term strategies such as day or swing trading, scalping emphasizes the need for precision. As a result, entering and exiting trades via simple market orders is frequently not enough, and an added degree of accuracy is required. Below are the primary order types used to execute scalping strategies:
- Market: After being placed, market orders are filled immediately at the best available price. Market orders often sustain significant slippage, contrary to most scalping methodologies. Nonetheless, they are often used to scalp in conjunction with momentum-based, automated strategies.
- Limit: Limit orders are placed upon the market and are not filled until price reaches the designated price point. Buy limit orders reside beneath current price, while sell limit orders are located above current price. Limits furnish the trader with accuracy and an exact market exit, making them perfect profit target candidates.
- Stop: Stops limit the downside liability of any given trade. Stop orders are not filled until price hits the designated price point, prompting closure of the open position. Buy stop orders are located above price, while sell stops reside below price.
One valuable tool in the scalper's arsenal is the bracket order. A bracket order is a fully-automated trade management device. Bracket functionality dictates that both profit target and stop loss orders are placed instantly following market entry. Brackets take the guesswork out of order location, a feature that scalpers find especially useful in rapidly moving, volatile markets.
Scalping remains one of the most popular trading methods in the current electronic marketplace. Independent retail traders and institutional investors employ various scalping strategies in pursuit of sustained, long-term profitability. As long as the risks are clearly defined and accepted, and the proper inputs are in place, scalping can potentially provide value and opportunity to nearly any trading operation.
As always, risk is inherent to investment, so forex traders can benefit from conducting their due diligence and/or consulting independent financial advisors before participating in range trading or other strategies.
This article was last updated on 13th August 2020.