A Beginner's Guide To Scalping In The Forex Markets

By Selwyn Gishen AAA

Scalping, at least in trading, is a term used to denote the "skimming" of small profits on a regular basis, by going in and out of positions several times per day. Scalping is not unlike day trading in which a trader will open a position and then close it again during the current trading session; in other words never carrying a position into another trading period or holding a position overnight. Whereas a day trader may look to take a position once or twice, or even a few times a day, scalpers are much more frenetic and try to skim really small profits multiple times in a session. And whereas a day trader may trade off the five-minute and the 30-minute charts, scalpers will often trade off of tick charts and one-minute charts. In particular, some scalpers like to try and catch the high-velocity moves that occur around the time of the release of economic data and other important news events, such as the release of the employment statistics or GDP releases if that is what is high on the economic agenda.

TUTORIAL: Beginner's Guide To MetaTrader 4

Why Scalp?
Scalpers like to try and scalp between five and 10 pips from each trade they make and to repeat this process over and over throughout the day. Using high leverage and making trades with just a few pips profit at a time can add up, especially if your trades are profitable and can be repeated many times over the course of the day. Remember, with one standard lot, the average value of a pip is about $10. So, for every five pips of profit made, the trader can make $50 at a time. Ten times a day, this would equal $500.

The Scalper's Personality
Scalping, though, is not for everybody, and one thing is for sure: You have to have the temperament to be a scalper. Scalpers need to "love" sitting in front of their computers for the entire session, and they need to enjoy the intense concentration that it takes to scalp. You cannot take your eye off the ball when you are trying to scalp a small move, such as five pips at a time. Even if you think you have the temperament to sit in front of the computer all day, or all night if you are an insomniac, you must be the kind of person who can react very quickly without analyzing your every move. There is no time to think. Being able to "pull the trigger" is a necessary key quality for a scalper. This is especially true in order to cut a position if it should move against you by even two or three pips.

The Difference Between Market Making and Scalping
Scalping is somewhat similar to what market makers do who trade around the spread. When a market maker buys a position he is immediately seeking to offset that position and capture the spread. Although the two types of investors serve different purposes, this is what a market maker does all day long. This is not referring to those bank traders who take proprietary positions for the bank.

The difference between a market maker and a scalper, though, is very important to understand. A market maker earns the spread, while a scalper pays the spread. So when a scalper buys on the ask and sells on the bid, he has to wait for the market to move enough to cover the spread he has just paid. In the converse, the market maker sells on the ask and buys on the bid, thus immediately gaining a pip or two as profit for making the market. Thus, the risk of a market maker compared with a scalper, although they are both seeking to be in and out of positions very quickly and very often, is much better for the market maker than the scalper. Market makers love scalpers because they trade often and they pay the spread, which means that the more the scalper trades the more the market maker will earn the one or two pips from the spread. (Find out how this tool magnifies both gains and losses. Check out Forex Leverage: A Double-Edged Sword.)

The Pros and Cons of Scalping
Scalping is very fast paced. If you like the action and like to focus on one or two minute charts, then scalping may be for you. If you have the temperament to react quickly, and have no compunction in taking very quick losses, not more than two or three pips, then scalping may be for you.

But if you like to analyze and think through each decision you make, perhaps you are not suited to scalp.

How to Set Up for Scalping
Setting up to be a scalper requires that you have very good, reliable access to the market makers with a platform that allows for very fast buying or selling. Usually the platform will have a buy button and a sell button for each of the currency pairs, so that all the trader has to do is hit the appropriate button to either enter or exit a position. In liquid markets, the execution can take place in a fraction of a second.

Picking a Broker
Remember that the forex market is an international market and is largely unregulated, although efforts are being made by governments and the industry to introduce legislation that would regulate "over the counter" forex trading to a certain degree.

As a trader, it is up to you to research and understand the broker agreement and just what your responsibilities would be and just what responsibilities the broker has. You must pay attention to how much margin is required and what the broker will do if positions go against you, which might even mean an automatic liquidation of your account if you are too highly leveraged. Ask questions to the broker's representative and make sure you hold onto the agreement documents. Read the small print.

The Broker's Platform
As a scalper you must become very familiar with the trading platform that your broker is offering. Different brokers may offer different platforms, therefore you should always open a practice account and practice with the platform until you are completely comfortable using it. Since you intend to scalp the markets, there is absolutely no room for error in using your platform. If you press the sell button by mistake, when you meant to hit the buy button, you could either get lucky if the market immediately goes south so that you profit from your mistake, but if you are not so lucky you will have just entered a position opposite to what you intended. Mistakes like these can be very costly. Platform mistakes and carelessness can and will cause losses. Practice using the platform before you commit real money to the trade. (Learn how to set each type of stop and limit when trading currencies. See How To Place Orders With A Forex Broker.)

As a scalper you only want to trade the most liquid markets. These markets are usually in the major currency pairs, such as EUR/USD or USD/JPY. Also, depending on the currency pair, certain sessions may be much more liquid than others. Even though the forex markets are trading for 24 hours a day, the volume is not the same at all times of the day. Usually, when London opens at around 3am EST, volume picks up as London is the major trading center for forex trading. At 8am EST, New York opens and adds to the volume being traded. Thus when two of the major forex centers are trading this is usually the best time for liquidity. The Sydney and Tokyo markets are the other major volume drivers.

Guaranteed Executions
Scalpers need to be sure that their trades will be executed at the levels they intend. Therefore, be sure to understand the trading terms of your broker Some brokers might limit their execution guarantees to times when the markets are not moving fast. Others may not provide any form of execution guarantee at all. Placing an order at a certain level and having it executed a few pips away from where you intended, is called "slippage."As a scalper you cannot afford slippage in addition to the spread, so you must make sure your order can and will be executed at the order level you request.

Redundancy is the practice of insuring yourself against catastrophe. By redundancy in trading jargon, I mean having the ability to enter and exit trades in more than one way. Be sure your internet connection is as fast as possible. Know what you will do if the internet goes down. Do you have a phone number direct to a dealing desk and how fast can you get through and identify yourself? All these factors become really important when you are in a position and need to get out quickly or make a change.

Choosing a Charting Time Frame
In order to execute trades over and over again, you will need to have a system which you can follow almost automatically. Since scalping doesn't give you time for in depth analysis, you must have a system that you can use repeatedly with a fair level of confidence. As a scalper you will need very short-term charts, such as tick charts, or one- or two-minute charts and perhaps a five-minute chart.

Getting Prepared to Scalp
1. Get a sense of direction
It is always helpful to trade with the trend, at least if you are a beginner scalper. To discover the trend, set up a weekly and a daily time chart and insert trend lines, Fibonacci levels and moving averages. These are your "lines in the sand", so to speak, and will represent support and resistance areas. If your charts show the trend to be in an upward bias (the prices are sloping from the bottom left of your chart to the top right), then you will want to buy at all the support levels should they be reached. On the other hand, if the prices are sloping from the top left down to the bottom right of your chart, then look to sell each time the price gets to a resistance level. Depending on the frequency of your trades, different types of charts and moving averages can be utilized to help you determine direction.

Figure 1 - EUR/USD Daily Chart
Source: Wordon Brothers
Figure 2: EUR/USD Weekly Chart
Source: Wordon Brothers

In the example above, the weekly chart shows a strong upward bias of the EUR/USD. The price could be heading back to a target of 1.4280, the previous high on November 4, 2010.

The daily chart shows the price has reached the 127.6 Fibonacci extension, at about 1.3975. Clearly there is a possibility of a pullback to the trend line somewhere in the vicinity of 1.3850. As a scalper, you can take the short side of this trade as soon as your shorter term charts confirm an entry signal.

2. Prepare your trading charts
Set up a 10-minute and a one-minute chart. Use the 10-minute chart to get a sense of where the market is trading currently, and use the one-minute chart to actually enter and exit your trades. Be sure to set up your platform so that you can toggle between the time frames.

Trading System
In the system shown here, and there are many other systems you can use to trade profitably, we've included a three-period RSI with the plot guides set to 90% and 10%. Only trades on the short side once the RSI crosses over the 90% plot guide, and the long side once the RSI reaches below the 10% plot guide, are entered. To nuance the signal, it's best to wait for the 2nd crossing into either of the two zones (only take the trade if the RSI goes into the zone - either the 10% for longs or 90% for shorts - on the second consecutive attempt.

Figure 3

Expectancy - Testing the System for Reliability
Now, before you follow the above system, test it using a practice account and keep a record of all the winning trades you make and of all your losing trades. Most often it is the way that you manage your trades that will make you a profitable trader, rather than mechanically relying on the system itself. In other words stop your losses quickly and take your profits when you have your seven to 10 pips. This is a scalping method and is not intended to hold positions through pullbacks. If you find that you can manage the system and you have the ability to pull the trigger quickly, you may be able to repeat the process many times over in one trading session and earn a decent return.

Remember that too much analysis will cause paralysis. Therefore, practice the methodology until it is automatic for you, and even boring because it becomes so repetitive. You are in the business of scalping to make a profit, not to boost your adrenalin or feel like you are playing in a casino. Professional traders are not gamblers, they are speculators who know how to calculate the risk, wait for the odds to be in their favor and manage their emotions.

When to Scalp
Remember, scalping is high speed trading and therefore requires lots of liquidity to ensure quick execution of trades. Only trade the major currencies where the liquidity is highest, and only when the volume is very high, such as when both London and New York are trading. (The unique aspect of trading forex is that individual investors can compete with large hedge funds and banks - they just need to set up the right account. Check out Forex Basics: Setting Up An Account.)

When Not to Scalp
Do not scalp if you do not feel focused for whatever reason. Late nights, colds and flu symptoms and so on, will often take you off your game. Stop trading if you have a string of losses and give yourself time to regroup. Do not try to get revenge with the market. Scalping can be fun and challenging, but it can also be stressful and tiring. You must be sure that you have the personality to indulge in high-speed trading. You will learn a lot from scalping, and then by slowing down you may find that you can even become a day trader or a swing trader because of the confidence and practice you may get from scalping. Remember though, scalping is not for everyone.

Always keep a log of your trades. Use screen capture to record your trades and then print them out for your journal. It will teach you a great deal about trading and even more about yourself as a trader.

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