Traders are often classified based on their trading frequency into various categories, such as day traders, swing traders, or position traders. Scalping is a common strategy used by day traders in order to realize small profits from temporary distortions in the financial markets. By mitigating risk ahead of everything else, the strategy works to produce stable risk-adjusted returns.
In this article, we’ll take a look at what scalping is, why it’s appealing, the mechanics of the trade, and other important considerations.
What Is Scalping?
Scalpers aim to profit from the difference between the bid and ask prices, sometimes in the role of a market maker or specialist. By making hundreds of short-term trades per day, these traders can accumulate larger profits over time even though the profit from each trade is relatively low. The positions are also only held for seconds or minutes, which limits the risk associated with each trade.
Often times, scalpers use tape reading in order to time their trades and maximize their profits. Tape reading involves using time and sales data to determine when and where to place trades. For example, a trader might notice blocks of stock being purchased in increments every day and then decide to buy ahead of the purchase and sell into the purchase to realize a small profit each time.
Be sure to also read about What is Swing Trading?
Longer-term scalpers may implement different strategies designed to take advantage of short-term technical tendencies. For example, a trader might always buy a stock as it breaks out from an ascending triangle pattern on higher-than-average volume and automatically sell after a 3% move higher. These dynamics are the opposite of “let your profits run” strategies, which are typical among technical traders.
Why Is Scalping Appealing?
Scalping is appealing to many traders due to its straightforward approach that applies in nearly any market environment. Since scalping opportunities may come about anytime, some traders also find these strategies useful as a supplement to a different trading style that they use more regularly. For example, position traders may use scalping strategies during choppy sideways markets.
Some key advantages to scalping include:
- Market Neutral. Scalping doesn’t rely on strong trends or directional movements, which means that traders can profit in nearly any market environment and avoid waiting on the sidelines.
- Limited Risk. Scalping involves buying and selling during the same day – and often within seconds or minutes – which limits downside risk from catastrophic events that occur overnight.
- Easier Moves. Scalpers target small price movements that occur with a greater frequency than larger trade setups, which means that consistent profits can be earned over time rather than waiting for a rare move.
- Simple Trades. Scalping strategies are generally very simple and involve specific rules for entry and exit, which removes a lot of the subjective decision-making from the trading process.
See also the 7 Psychological Traps Every Trader Must Face
Mechanics of the Scalp Trade
Scalpers make from ten to hundreds of trades per day using a variety of different tools designed to spot opportunities depending on their preferred strategy. A primary scalper probably uses a direct access broker while looking at one-minute charts, level two quotes, total view, and time/sales data for their preferred set of equities in order to determine high-probability entry points.
A trader using scalping as a supplemental strategy may decide to utilize a so-called “umbrella” strategy to first identify long-term trends and then look for shorter-term trades in the same direction as scalping opportunities. For example, a trader may decide to only make short-term buys if a short-term moving average is trending above a long-term moving average for a given equity.
Learn more about High Frequency Trading
In general, scalpers can be classified as market makers that try to capitalize on the bid/ask spread, bulk buyers that purchase a large number of shares and sell them for a gain on very small price movements, and technical scalpers that enter a trade based on a technical signal and close the position as soon as the first exit signal is detected with a 1:1 risk/reward ratio.
Risks & Other Considerations
Scalping may help reduce many risk factors, making them attractive to short-term traders, but there are still several important risks to consider. After all, if scalping was capable of generating risk-free profits, the markets would eventually eliminate any potential profit over time! Investors should keep these considerations in mind before embarking on a scalping strategy in order to avoid sudden losses.
Some key risks associated with scalping include:
- Slippage. Scalping involves profiting from small price movements, which means that it’s important to get accurate quoted prices. Even a little slippage can result in quick losses on frequent trades.
- Discipline. Scalping requires fast entry and exit from trading positions with very small margins for error, given the tiny profit margins. After all, a single large loss could eliminate literally thousands of small profits.
The Bottom Line
Scalping can be a very profitable trading strategy for both pure scalpers and those using the strategy as a supplemental option. That said, traders should be very disciplined and experienced with using short-term trading tools like one-minute charges, level two quotes, and similar tools. Scalping may also require a lot of practice in order to master and generate high risk-adjusted returns.
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