Scalping is a trading style specializing in taking profits on small price changes, generally soon after a trade has been entered and has become profitable. It requires a trader to have a strict exit strategy, because one large loss could eliminate the many small gains the trader has worked to obtain. Having the right tools, such as a live feed, a direct-access broker and the stamina to place many trades is required for this strategy to be successful.
Scalping is based on an assumption that most stocks will complete the first stage of a movement (i.e., a stock will move in the desired direction for a brief time), but where it goes from there is uncertain. After that initial stage, some stocks will cease to advance, and others will continue.
A scalper intends to take as many small profits as possible, not allowing them to evaporate. This is the opposite of the "let your profits run" mindset, which attempts to optimize positive trading results by increasing the size of winning trades while letting others reverse. Scalping achieves results by increasing the number of winners and sacrificing the size of the wins. It's not uncommon for a trader with a longer time frame to achieve positive results by winning only half or even less of his or her trades – it's just that the wins are much bigger than the losses. A successful scalper, however, will have a much higher ratio of winning trades versus losing while keeping profits roughly equal or slightly bigger than losses. (See also: Introduction to Trading: Scalpers.)
Scalping: Small Quick Profits Can Add Up
The main premises of scalping are:
- Lessened exposure limits risk: A brief exposure to the market diminishes the probability of running into an adverse event.
- Smaller moves are easier to obtain: A bigger imbalance of supply and demand is needed to warrant bigger price changes. For example, it is easier for a stock to make a 10-cent move than it is to make a $1 move.
- Smaller moves are more frequent than larger ones: Even during relatively quiet markets, there are many small movements that a scalper can exploit.
Scalping can be adopted as a primary or supplementary style of trading.
Scalping as a Primary Style
A pure scalper will make a number of trades a day, perhaps in the hundreds. A scalper will mostly utilize one-minute charts since the time frame is small, and he or she needs to see the setups as they shape up in as close to real time as possible. Supporting systems such as Direct Access Trading (DAT) and Level 2 quotations are essential for this type of trading. Automatic instant execution of orders is crucial to a scalper, so a direct-access broker is the preferred weapon of choice. (For more, see: Direct Access Trading Systems.)
Scalping as a Supplementary Style
Traders with longer time frames can use scalping as a supplementary approach. The most obvious way is to use it when the market is choppy or locked in a narrow range. When there are no trends in a longer time frame, going to a shorter time frame can reveal visible and exploitable trends, which can lead a trader to scalp.
Another way to add scalping to longer time-frame trades is through the so-called "umbrella" concept. This approach allows a trader to improve his or her cost basis and maximize a profit. Umbrella trades are done in the following way:
- A trader initiates a position for a longer time-frame trade.
- While the main trade develops, a trader identifies new setups in a shorter time frame in the direction of the main trade, entering and exiting them by the principles of scalping.
Practically any trading system, based on particular setups, can be used for the purposes of scalping. In this regard, scalping can be seen as a kind of method of risk management. Basically, any trade can be turned into a scalp by taking a profit near the 1:1 risk/reward ratio. This means that the size of the profit taken equals the size of a stop dictated by the setup. If, for instance, a trader enters his or her position for a scalp trade at $20 with an initial stop at $19.90, then the risk is 10 cents; this means a 1:1 risk/reward ratio will be reached at $20.10.
Scalp trades can be executed on both long and short sides. They can be done on breakouts or in range-bound trading. Many traditional chart formations, such as a cups and handles or triangles, can be used for scalping. The same can be said about technical indicators if a trader bases decisions on them. (See also: Top Technical Indicators for a Scalping Trading Strategy.)
3 Types of Scalping
The first type of scalping is referred to as "market making," whereby a scalper tries to capitalize on the spread by simultaneously posting a bid and an offer for a specific stock. Obviously, this strategy can succeed only on mostly immobile stocks that trade big volumes without any real price changes. This kind of scalping is immensely hard to do successfully, as a trader must compete with market makers for the shares on both bids and offers. Also, the profit is so small that any stock movement against the trader's position warrants a loss exceeding his or her original profit target.
The other two styles are based on a more traditional approach and require a moving stock where prices change rapidly. These two styles also require a sound strategy and method of reading the movement.
The second type of scalping is done by purchasing a large number of shares that are sold for a gain on a very small price movement. A trader of this style will enter into positions for several thousand shares and wait for a small move, which is usually measured in cents. Such an approach requires highly liquid stock to allow for entering and exiting 3,000 to 10,000 shares easily.
The third type of scalping is the closest to the traditional methods of trading. A trader enters an amount of shares on any setup or signal from his or her system, and closes the position as soon as the first exit signal is generated near the 1:1 risk/reward ratio, calculated as described earlier.
Tips for Novice Scalpers
With low barriers to entry in the trading world, the number of people trying their hands at day trading and related strategies such as scalping has increased. Newcomers to scalping need to make sure the trading style suits their personality. Scalping requires traders to follow a disciplined approach, make quick decisions, spot opportunities and constantly monitor the screen. Traders who are impatient and feel gratified by picking small successful trades are perfect for scalping.
That said, scalping is not the best trading strategy for rookies, as it involves fast decision-making, constant monitoring of positions and frequent turnover. However, there are a few tips that can help novice scalpers.
Order Execution: A novice needs to master the art of efficient order execution. A delayed or bad order can wipe out what little profit was earned and even result in a loss. Since the profit margin per trade is limited, the order execution has to be accurate. As mentioned above, this requires supporting systems such as Direct Access Trading and Level 2 quotations.
Frequency & Costs: A novice scalper has to make sure to keep costs in mind while making trades. Scalping involves numerous trades, as many as hundreds during a trading session. Frequent buying and selling is bound to cost in terms of commissions, which can shrink the profit. This makes the decision to choose the right online broker crucial. The broker should not only provide the requisites like direct access to markets, but also competitive commissions. And remember, not all brokers allow scalping.
Trading: Spotting the trend and momentum comes in handy for a scalper, who can even enter and exit briefly to repeat a pattern. A novice needs to understand the market pulse, and once the scalper has identified that, trend trading and momentum trading can help achieve more profitable trades. Another strategy used by scalpers is countertrend; however, beginners should avoid using this strategy and stick to trading with the trend.
Trading Sides: Beginners usually are more comfortable with trading on the buy side and should stick to that before they gain sufficient confidence and expertise to handle the short side. However, scalpers eventually must balance long and short trades for the best results.
Technical Analysis: Novices should equip themselves with basics of technical analysis to combat increasing competition in the intra-day world. This is especially relevant in today's markets dominated by high-frequency trading, as well as the increasing use of dark pools.
Volume: Scalping as a technique requires frequent entry and exit decisions within a short time frame. Such a strategy can only be successfully implemented when orders can be filled, and this depends on liquidity levels. High-volume trades offer much-needed liquidity.
Discipline: As a rule, it is best to close all positions during a day's trading session and not carry them to the next day. Scalping is based on small opportunities that exist in the market, and a scalper should not deviate from the basic principle of holding a position for a short time period. (For related reading, see: Day Trading Rules for Rookies: Don't Play It by Ear!)
The Bottom Line
Scalping can be very profitable for traders who decide to use it as a primary strategy, or even those who use it to supplement other types of trading. Adhering to the strict exit strategy is the key to making small profits compound into large gains. The brief amount of market exposure and the frequency of small moves are key attributes that are the reasons why this strategy is popular among many types of traders. (For more, check out: Scalping vs. Swing Trading.)