Scalping Basics: what it is, and how it works

Scalping is a trading technique that involves opening and closing positions intraday in a variety of instruments such as FX, Futures or CFDs. Scalpers will aim to profit from small price movements in their trading positions, and tend to trade much more frequently than medium to longer term “trend” following traders. It is not uncommon for them to trade more than ten times a day.

Many websites and research sources are long on scalping definitions but short on scalping strategies. This is mainly because there is not just one single method of scalping, with there being plenty of variation under the hood. For some, scalping is no more than sitting on the bid and offer in a liquid stock like BHP and hope that the spread can be captured. For others it is a case of undertaking a long/short trade in a large number of share CFDs. Once the trader gets a signal from their trading system they can rapidly enter into a new position. If the share price moves in the correctly anticipated direction, the scalper can quickly close out the position for a profit.

Advantages

The brief amount of market exposure and the frequency of small moves make this strategy popular among many types of traders. By reducing time to market exposure (with most scalping trades lasting only a few minutes or hours), traders mitigate two of the major risks of trading, namely the probability of “gap” risk, or news drivers.

Small price moves occur a lot more frequently than larger ones, and so even in quieter market conditions there are generally always opportunities.

Disadvantages

Markets are fast moving and subject to large intraday swings. By anticipating extremely short term moves in price, scalpers can be wrong footed by the direction of the market and so may run their losses whilst taking very small profits.

Frictional costs such as bid/offer spreads, broker commission and trading losses can quickly erode small, but consistent profits. Therefore scalpers have to be extremely disciplined in selecting potential trades, and have a broker that is suited for scalping.

Basics

• To be a successful scalper, it is much simpler to trade with the current market trend. In an up-trending market, make more long trades, and conversely, in a down-trending market, make more short trades.
• Always place a stop-loss order. This is important when placing a trade and keep moving your stop up (or down if short) when trades are in profitable territory.
• However tempting, don’t keep your positions open overnight. This can be very dangerous as the market can “gap” substantially through your stop loss due to movements in offshore markets.
• Keep trades to a minimum around market open/close. The market direction is usually harder to predict around market open/close as there is often larger trading volumes being executed.
• Ensure your computer and internet connection is fast. Scalping requires rapid responses when moving in and out of positions.
• Subscribe to real time, level II market data (depth of market), which lists the highest bid and lowest ask prices for a stock. Many brokers who offer Direct Market Access (DMA) CFD access will often not charge high frequency traders for this service. As scalping works on the basis of “buying low, selling high” (and vice versa) choose a broker who allows you to interact in the bid/offer spread – you want to be a price maker and not a price taker.
• Positive Mental Attitude. This is an extremely important factor for successful trading, particularly in short-term trading.

Types of Scalping

Trading the bid/offer spread.

Scalpers will often identify stocks that trade large volumes without any real price change. This kind of scalping is immensely hard to do successfully, as a trader must compete with other market participants for the shares on both bids and offers.

Technical trading.

The technical scalper will hope to profit from intraday price swings and will seek out points of support, resistance and breakouts. One minute charts are the most useful reference point.

Company News.

Trading on company news is another popular method used by scalpers. However, it is important to note that major company news events in Australia are often preceded by “notice received” which means the shares are suspended until such time that an orderly market can be re-established (this can last a few minutes or it can last days). This practice obviously may limit the effectiveness of the scalper.

Automated Order Type.

One popular order type used by institutions and hedge funds is VWAP or volume weighted average price. Slicing and dicing an order over the day means large orders will not impact the market as much as if the order was simply executed at “market” that is at any price. Scalpers will often search for stocks that are subject to VWAP because they can profit by effectively anticipating that the order quantity will drive the price up (or down) over a given time period.

Targeting Stop Loss Orders.

These are often placed at round numbers, such as $10.00, $9.50, $9.00. Opportunities arise from understanding this psychology as scalpers can in effect take the “other side” of the trade, in the knowledge that once all the stops are liquidated the trend in share price may well reverse in their favour.