What is scalping? Beginners Guide to Trading Strategies
Scalping is a popular short-term trading style that involves taking small but frequent profits. Find out what scalping is and how you can start scalping the financial markets, including forex and stocks.
What is scalping?
Scalping is a trading style that aims to profit from small price changes in the financial markets. Instead of buying and holding positions over a long period of time, scalpers make quick profits on a high volume of shorter trades, which often only last a few seconds or minutes.
The theory behind the style is that smaller price moves are more frequent, and therefore easier to capture, than larger ones. By entering and exiting larger positions quickly, the smaller gains add up to the same level of profit from a normal day trade. By entering trades at a larger volume, even a profit of a few cents would add up – but so would the risk associated with the position.
Scalping requires a strict trading strategy, which defines exactly when to enter and exit positions and how much capital will be invested on each position.
An exit strategy is particularly important in scalping because allowing a single trade to take losses could eliminate a large portion of any capital earned. Scalp traders will use take profit and stop loss orders to automate these entry and exit targets.
What is a scalping trader?
A scalper trader is the name of a person who uses the scalper style of trading. Technically, scalpers are also day traders because they never hold open positions overnight, but there are a few traits that set them apart.
Scalping traders are often extremely disciplined individuals, due to the need to be strict about how long they keep positions open. They have the complete opposite view of “let your profits run” and will instead restrict trades to very specific profit targets, and even stricter loss levels. Scalpers would never wait to see if a losing trade would turn into a winning trade.
A scalper trader will also need to be able to spend a lot of time monitoring the financial markets, given that a pure scalper would enter dozens or even hundreds of trades each day. For this reason, it is very rarely a style of trading adopted by beginners or part-time traders.
Scalping traders can manually make decisions about when and what to trade, but they generally overlap with the class of traders who prefer to automate their trading strategy. Due to the amount of work required for a successful scalping strategy, it may be more profitable and faster to use a computer program. This ensures that positions are entered and exited quickly and reduces the risk of trading based on emotions and biases.
While investors hold stocks for years, and even position traders hold stocks for months, scalpers would hold a position in a stock for minutes or seconds.
A stock dealer can buy a large volume of stock, wait for a tick up – or sell a stock and wait for a small tick down – and unload the trade as soon as it hits a profit.
For example, you place a limit entry order to buy 1000 shares of company A when it reaches $500 per share, a known support level. Company A’s shares drop to $500 and your trade is executed. You start watching the market and are ready to close your trade if the market moves in your favor or against you.
The market rises to $501 and your trade is closed whether the price seems to continue to rise or not. From this small position, the potential profit would be $1000.
However, if the market turned quickly, the losses could have piled up. This is why risk management is equally important, and most scalpers use stop-losses.
Liquidity is also essential when scalping stocks, as without it it would be difficult to move a large number of stocks at once. This creates a number of problems when scalping, the most obvious being that you may be forced to hold your position for longer than you want. It could also lead to further spread.
Every cost incurred on a scalp trade is significant as they can add up due to the number of trades entered each day.
Scalping currencies in forex
Forex scalping involves trading currency pairs over very short periods of time, in large numbers. Many forex scalpers will focus on high volatility events around economic data and breaking news, where big market moves are almost guaranteed.
A standard lot in forex is equal to 100,000 units of the base currency, but thanks to leverage, scalpers can continue to take larger positions and dodge smaller market moves. The average value of a pip is around $10, so holding a trade for one pip movement ten times a day would equal $100.
Normally, forex scalpers will have a set number of pips in mind and will close their position once the currency pair has moved that amount in either direction.
For example, a scalper can only open a trade on GBP/USD which only lasts 30 seconds, with the aim of covering a one or two pip movement in the currency pair. Taking the average, this might only earn them a profit of $10-$20, but it would repeat many times throughout the day.
Is scalping profitable?
A scalping trading strategy can be profitable, provided you have a higher ratio of winning trades to losing ones.
It may seem obvious, but in other trading styles, one losing trade may not wipe out all your hard work. Traders with longer timeframes, such as day traders or position traders, may earn less than half of their trades and still make a profit. While scalpers could see all their hard work disappear in the blink of an eye.
Broadly speaking, there are three main strategies that scalpers employ:
- High volume trading – Scalpers often buy in large quantities to get the most out of a small move, sometimes just a few points. As mentioned earlier, this approach requires enough liquidity for the full position to be opened and closed efficiently and with a tight spread.
- Breakout Trading – Most scalping trading strategies will involve looking for breakouts, positioning your entry in a trade at the start of a breakout, and following the movement of the market until the first exit signal is issued. This strategy is probably the most accessible, as it is used in all trading styles.
- Negotiate the spread – Also known as market making, this is a strategy in which scalpers attempt to profit from the spread itself by simultaneously buying and selling an asset. It relies on a relatively stable but still popular enough market to experience significant liquidity. This is the most difficult strategy as the trader will face much larger institutions and market makers.
While most traditional scalping techniques are based on going “long” (long), an area of opportunity can also be opened by going “short” (short) – especially when it comes to market making strategies that involve buying and selling.
You can go long and short using derivatives, such as CFDs, options, and futures.
How to scalp a market
The first step to start scalping a market is to find a broker which gives you the features and tools you’ll need to execute your strategy effectively. At a minimum, this should include:
- Fast and reliable execution – you need to make sure your broker has a best execution practice to ensure you get the best prices, even in volatile markets.
- Competitive costs and fees – profits can be swallowed up by the high costs of trading fees and commissions. You will need to ensure that your provider offers a competitive rate.
- Advanced graphics – the trading platform you have chosen should offer multiple timeframes on the charts. If you open and close trades in seconds or minutes, a tick of 10 minutes or longer isn’t too helpful.
- Technical analysis indicators and chart analysis tools – most scalpers will focus more on price action and identifying known chart patterns rather than chartist analysis.
- Up-to-date news and analysis – staying on top of “hot” news and trades each day will help you know where opportunities lie and what is likely to trigger sudden price changes.
- Appropriate risk management tools – stop and limit orders are at the heart of a scalper’s toolkit, being able to attach them before and during your trade can mean the difference between a winning and losing trade.
Before you consider applying your scalping strategy to live markets, it is worth practicing first on a risk-free demo account. You will be able to use virtual money, eliminating any risk to your own capital, and start with smaller position sizes to ensure you are on the right track before opening a live trading account.
By Rebecca Cattlin, FOREX.com » Official Site
Disclaimer: The information and opinions contained in this report are provided for general information only and do not constitute an offer or solicitation to buy or sell forex exchange contracts or CFDs. Although the information contained herein is from sources believed to be reliable, the author does not warrant its accuracy or completeness, and assumes no responsibility for any direct, indirect or consequential damages that may result from anyone relies on such information.