What is scalping?January 18, 2021 2021-06-05 13:11
What is scalping?
Scalping is a term used for very short term trading. It can be holding a trade for only a matter of seconds or a couple of minutes. If you’re scalping you won’t be holding positions for over an hour, that would be considered day trading or swing trading.
Scalping is the fastest type of trading that a human can do, we have invented algorithms that can trade faster but that is a different style in itself.
If you trade for short periods of time and use scalping strategies, you would be known as a scalper.
Scalping – how do you do it?
Scalping is a style of trading determined by its time frame, you can use any number of strategies to scalp but you must hold positions for short periods of time.
You’re holding positions for a few minutes. Really, if you’re holding over 15-30 minutes it isn’t considered as scalping. You’re veering into ‘day trading’ territory there, for more information on day trading, check out our lesson ‘What is day trading?’.
When you’re scalping you need to be paying attention to the markets constantly and looking for very short term opportunities.
You need to be prepared and this requires planning. Depending on the strategy you’re using, you should know where you want to enter and exit trades before the market gets there. Once the price gets to your levels, you can then simply execute the trade and already have the plan in place.
During the day, you could get up to 100 opportunities, so it’s important you’re at your screens analysing the market and how the price is moving.
Do you follow the trend when scalping?
Yes and no. Due to the short term nature of scalping you want to be looking for any. Because markets move in waves, you may well be going with and against the trend several times throughout the day.
In short, it doesn’t really matter which direction you’re trading. But saying that, as with all trading strategies, it normally has a higher percentage of success if you do go with the trend.
You therefore don’t need a view of the underlying market, simply finding important levels where you expect a reaction could be your strategy. You should be able to adapt to the market conditions and use the signals to choose a direction.
For example, you might have bought GBPUSD, and then seen signals that the market will fall. You would exit your long trade and enter a short trade. Taking advantage of the short term moves.
If you’re scalping you will need to be more flexible and open to changes in market sentiment.
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Managing your risk when scalping
When you’re scalping because you’re only looking for short term moves, it is difficult to get a large risk to reward ratios, therefore their hit rate is normally very high.
As a scalper, your stop loss will often be very tight to your entry price. This is because for you to make the correct profit according to your risk strategy, you need to have larger positions to profit from the small moves.
It is high-risk trading because your stop is so close. Any excessive increases in the spread can hurt your returns. Therefore it is always advised that scalpers find the brokers with the very best spreads or no spreads at all. Perhaps paying an agreed commission.
In more traditional trading styles, swing and position trading, you would be looking for a risk-reward ratio above 1:1 (ideally over 2:1) with a hit rate sometime below 50%. With scalping your hit rate may be considerably higher (60-80%) but risk-reward ratio would be lower.
Scalping trade exposure
Another key feature of scalping is the amount of exposure you have to the markets. It’s often higher than other styles of trading.
Normal recommendations of risk are that you would not have any more than 1% of your account at risk per trade. A scalper may be looking to risk small amounts based on their risk strategy and pips targeted but their absolute amount per trade is considerably higher. Although the risk should still not be more than 1%. This is because they are forced to place larger trades.
To be a successful scalper you need to be ready to enter a trade at any time. Opportunities can show themselves at any point. With experience you will learn better opportunities than others and sometimes being reliant on your gut can be effective (only if you’re experienced).
Why is scalping important?
Asking whether a trading strategy is important is a bit odd because it is important to you if you’re the trader and are successful at it. Scalping is the same in this context, if it’s part of your strategy because it suits your trading style then yes it is important. For others, it might be important not to use scalping because they’re not profitable with it.
It’s important to know that scalping is a time-intensive strategy, you must be able to put aside lots of hours of the day to fully benefit from scalping.
Scalping is also important because it delivers significant liquidity to the financial markets, the same way day traders do. Scalpers are constantly active in the markets, taking trades every minute, which means there are a lot of orders and volume going through the market.
It, therefore, makes it easier for you and I to enter the market at the price we want to.
Algorithmic trading is also based on scalping strategies and again adds considerable volume and liquidity to the markets. These trading machines can take lots of trades a second and are starting to have a big impact on how markets move.
What are the best scalping strategies?
You can use lots of different scalping strategies. Lots of them will be similar to day trading strategies but just based on smaller time frames (1-5 minutes).
Some scalpers use their gut instinct to trade but this comes with experience, so we wouldn’t advise any beginners try this as a technique.
Strategies can often be difficult to define, which is why it is often hard to put defined strategies on paper.
We take a look at some of the most popular strategies that you can define.
Support and resistance breakouts (stop hunting)
A common and popular strategy used by scalpers is based on breakouts and reversals from technical levels of support and resistance. As you’d guess, these are short term levels, although you can use some longer-term levels.
The problem with longer-term levels is that they might be more of a zone rather than an exact level, therefore it’s more difficult to determine the break.
Steps to scalping using support and resistance:
- Identify key support or resistance level
- Use a short time frame, probably a 1-minute
- Wait for a 1-minute candle to break through the level
- Wait for confirmation of the break (this would be part of your strategy but might be the close of an impulsive candle or a separate indicator)
- Take the trade
- You should see a fast impulsive move as the market starts to trigger other traders stop losses
- Exit the trade either at the next level or when the market begins to slow
Other traders tend to place their stop losses below and above key levels, therefore if they break, the market will likely run into the stop losses which will cause the market to continue in that direction initially.
This is often referred to as stop-hunting. This also happens on larger time frames as well.
News and data scalping
Lots of scalpers avidly follow breaking news and data releases. they will use squawk services and economic calendars to plan when they’re going to be active in the market.
There are two main approaches when it comes to trading the news. First is to go with the initial move and second is to trade the reverse of the initial move.
Scalp with the news
The first approach is to go in the same direction as the market and the news. This would mean if the news was bullish, then you’d be looking to buy the market.
You can also look for data releases. Analysts will predict what they expect the data to be, therefore any extreme deviation from this prediction will cause the market to move in either direction. Therefore waiting for that number and trading immediately is also an option.
You would need to understand what impact this data will have on the market, so reading about the fundamentals is important with this strategy.
You will know the time and date of the data releases, therefore allowing you to plan your day. The key to being successful when trading with the news is to understand what the news means for the market and reacting quickly.
You might find that the market goes without you because it can move very quickly!
Scalp the news with an OCO order
A popular strategy when trading the news is using an OCO order. This stands for order cancels order.
This entails you placing a buy order above the price and a sell order below the price. You place these orders just before the news is to be released and then whatever the result of the news (bullish or bearish), you should have an order ready to take a trade.
Whatever direction the market goes it will execute either your buy or sell order. The order that was not executed will be removed from the market.
While this is an effective strategy, it does come with risks and does take time to perfect. Therefore testing it on demo is always advised.
One of the main risks is that when you place the order, the market becomes volatile, which causes spreads to increase. Therefore there is a chance that you might get triggered before the news is released.
That would be if you placed the orders too tight to the market, the alternative would be if you placed the orders too far away. You might not then benefit from the move at all.
Scalp the fade
The other strategy for trading the news is to fade the move. This means allowing the initial move to happen and then trade the reversal back to its original levels.
Often the initial reaction is almost a knee jerk reaction and the market will come back to its original levels. You can trade this reversal.
Scalp the fade with predetermined levels
The best strategy to fade the news is to highlight predetermined levels before the news is released. You would then watch the market approach those levels and look to open positions once you receive the right signals.
Signals might include a one-minute reversal candlestick or an overbought or oversold indicator.
Due to algorithmic trading, it is often difficult to manually trade with the news because the algorithms are so fast, therefore fading the news is a popular option.
Moving average scalping
As previously mentioned you can use similar strategies to the day trading ones we mentioned in our previous lesson by simply reducing the time frame.
A popular one for scalpers is using moving averages. Either by using them as support and resistance and trading the same way as the support and resistance strategies mentioned above or by using multiple moving averages.
When using multiple moving averages, you would be looking for a cross. For example:
- Use the 8 and 21 exponential moving averages (EMA)
- Wait for the 8 EMA to cross above the 21 EMA
- Take a long position
This is because the faster moving average crosses the slower one, indicating that the short term trend is higher.
There are of course lots of different variations you could use of moving average. Different speeds and more than two if you wanted. There are thousands of technical analysis strategies you could use, it’s about finding one you’re comfortable with.
We’ve looked at what scalping is, why it’s important and how you do it, as well as some key strategies to get started with.
The key things you should takeaway:
- Time intensive – You will find yourself spending a lot of time watching the screens looking for opportunities
- Risk and reward – The risk to reward is slightly different compared to day trading and other styles of trading
In our next lesson, we will look at What Is Price Action? Link to next lesson What Is Price Action?