Scalping is the term used to refer to a trading strategy that concentrates on making profits due to small price changes, generating a quick profit off reselling. This prime day traders’ strategy is the one in focus today as part of our guide articles series, where we aim to increase your knowledge of the inner and outer workings of the trading world.
In this article, we will be discussing:
- The premises scalping stems from
- How Scalping is carried out
- Scalping vs. Other Trading Strategies
- Advice for Beginners at Scalping
Now while there could be a lot of subjective points to make on a certain trader’s way of thinking, coming to the land of objectivity brings us back to how scalping.
1. The premises scalping stems from
Scalping is based on the premise that a large imbalance of supply and demand is required for there to be major price changes in the value of a security. Hence, for large profits, there need to exist disparities between supply and demand. This means that the small profit that comes as a result of scalping is easier to obtain because, as stated earlier, gaining the small profit did not depend on huge supply and demand imbalances. They could be gained comparatively easily as large gains from huge imbalances are more difficult to obtain and exploit.
Scalping also implies that it would hence be more probable that security will make a $0.1 jump above or below its previously held price than it making a $1 move. In simple words, it is easier for a security to have a small price change instead of a big one.
Since the entire method relies on quickly buying and reselling after exploiting the small price change, the exposure to the volatility of the market is present only for a short amount of time. Scalping implies that the lesser duration you are exposed to the market, the lesser the chances of an unfortunate anomaly. Thus, given this third premise, scalping is favored due to the trader being exposed to the market for a short duration of time which minimizes the chances of loss.
2. How Scalping is carried out
Since Scalpers prefer the short profits, they can earn exploiting the small price changes that occur in a securities price. They keep tight trading windows. This means defining their trade in terms of both their time duration and price movement. This means that a scalper strictly gets out of a trade once their profit target has been hit. This means no “waiting around” to see if their profits could be more than their desired profit value. However, having a tight trading window could also be seen in a different light. The trader also gets out of a trade as soon as they reach their target loss level. This means as soon as they reach a level of loss, they decide to end the trade. They cannot wait around to see if the entire trade turns around.
Now whether the trader makes these decisions (of continuing their position or closing it) before or as the trade is going depends on what kind of a trader we are dealing with. Discretionary scalpers make decisions as they progress into their position. They swiftly make conclusions on their idea of a security’s value and start their trade. Note that when it comes to Discretionary scalpers, the parameters of the trade are determined by the trader. For example, the time at which the trader opened their position, how long they kept it open for, etc.
Now looking at the other side of the coin, we have systematic traders. These can be described as quite strict in their dealing with scalping trades where it is not the trader themself, but rather a computer program that initiates a trade, holds a position, and closes it according to parameters already set by the trader. These parameters can include the maximum level of profit or loss that will close the trade, the pattern which the computer program is supposed to look out for to initiate a trade, and so on.
The use of such computer programs is increasing and is considered the lesser-risk posing method of scalping as it takes away the reliance on human emotions in the beginning and closing of a trade. Moreover, if the patterns to look for the presence of to initiate trading are reliable themselves, this would mean a lesser chance of errors in properly starting trades. The computer program will begin a trade as it is programmed to do without asking the trader to assess that action, and it will stop a position once the maximum profit or loss has been reached. More or varied features may be present as technologies such as Artificial Intelligence advance every day.
As most people have their own way of going about many things, the same is true for trading strategies. Most people will have their own way of implementing what they have interpreted with their own beliefs and ideas in mind intended to help them reach their desired goals.
When it comes to Scalping, many stick to doing it purely where the trader is associated with a large number of trades a day – the number potentially in the hundreds or even above. Since profits earned are comparatively small, more trades need to be done in order to accumulate a useful profit.
Also read:The trader usually has access to Level 2 quotations and Direct Access Trading (DAT), which both ensure the trader is able to make decisions based on as close to real-time information as possible. Level 2 Quotations is a service run on a subscription-based model that provides real-time access to the NASDAQ order book, giving a bird’s eye view to investors and traders of what is going on in the market. Direct Access Trading allows these very scalpers to execute their trades as swiftly as possible as they allow traders to trade on electronic communications networks. A scalper usually has many other tools as part of their scalping toolkit; however, the two mentioned above are the most common and likely to be used.
Coming to how Scalpers assess what could be a profitable trade vs. a loss-likely one, it all comes down to the technical analysis carried out by the trader. This is likely to include an assessment of the securities’ past price movement and dissecting patterns via which the trader can strategize trade entry and exit points. Patterns and indicators allow scalpers to make a judgment as to whether a particular securities’ price would go up or down, and using this information do the scalpers then set up their maximum profit or loss levels and hence begin trading.
This technical analysis approach is one that is au contraire to the fundamental analysis approach. This is where financial records of a company a trader is willing to invest in will be taken into account, along with other factors that key in to allow the trader to evaluate a company’s worth. The reason why technical analysis approaches are more preferred over fundamental analysis is because of the short duration the scalper is opening his position for and expecting a price change. Hence, for scalpers, a technical analysis approach is always preferred.
However, do note that while there may exist completely separate and scalping-oriented computer systems, most scalpers use common trading systems as any trading system can essentially be used for the purposes of scalping. The underlying method is somewhat risk-management, as the risk/reward ratio in scalping is usually 1:1. This means that the investor is willing to lose exactly as much amount as they are willing to gain. For instance, if a trader opens her position for $10. They would close the position if the price changes to either $9.90 or $10.10. This means the amount they could lose equals the amount they could gain and hence, a 1:1 risk/reward ratio.
Scalpers uncommonly try to cash in on the bid-ask spread by bidding and asking at the same time. This is also referred to as “market-making.” This is difficult to pull off as not only is the scalper going to have to look for stocks that are immobile, but the trader is also going to have to find stocks that trade large volumes without significant price changes. Also, this approach is riskier as the profit to be gained is very small, and any price movement unforeseen by the trader is likely to result in losses greater than their initial profit target.
As this is the more difficult approach, it is usually avoided by traders and hence are born the more traditional of approaches.
Scalpers can also try to buy a large number of shares of stocks where there is rapid movement. This, like all things mentioned in this article, requires good sound knowledge and strategy. Scalpers going for this approach would enter a position for thousands of shares and exit as soon as a very small price change takes place. This was outlined earlier in this very article. The small price movement could very well be measured in cents.
As immediately buying thousands of shares and selling them requires the stock to be liquid, the traders look for a small bid-ask spread. Scalpers usually use computer programs to enter the specific number of shares they need to buy, and the position is exited as soon as the price change equals the 1:1 risk/reward ratio.
3. Scalping vs. Other Trading Strategies
As you have read already, scalping is a trading technique referred to buying security, waiting for a small price movement, and then exiting the position taking away whatever you gained or lost. Since scalpers lookout for small price movements, and they hold the promise of “lesser time exposed to the market equals lesser risk,” this makes them hold their position for small durations. Ranging from a few seconds to a few minutes, it is uncommon for a scalper to hold their position for hours. As the duration is relatively short, scalping comes under the category of Day Trading.
Now within Day Trading itself exist many strategies. Hence it is useful to compare scalping to at least one of those in order to have a better idea than otherwise as to how scalping stands compared to other options a trader might have.
Using daily pivots is an example of a day trading strategy. Daily Pivots involves taking into account the volatility of the security and of the market perhaps and intending to make a profit exploiting it. The volatility of the market, or how “volatile” the market is, is a measure of how much the market is going “up or down.” These “up and down” movements may be called fluctuations, and they may happen in response to political, regulatory, or other related news.
Securities, like stocks, for example, have daily volatility. Daily Volatility, in this case, basically refers to the range in which the price of the stock is expected to lie as the day goes by. A day trader can profit off this.
A day trader uses the data available of the past high, low, and closing prices of the security in focus to predict what the high, low, and closing prices of the security can be for the day. This is done via advanced systems, ideally looking at a lot of factors in order to make an accurate prediction. The day trader does this to calculate support and resistance levels. Support level can be defined as the price level under which the price of a security is not supposed to fall for a certain time duration. It can be simply defined as the minimum expected price for a period of time. Resistance levels can be defined as the opposite of support levels, where it is the price level the security meets pressure to not move beyond.
Day traders using daily pivots would buy securities at the price which is considered low for the day and then wait till the price goes up during the day. When and what the “low price” and the “high price” are, are calculated using the support and resistance levels. This allows the trader to determine the entry and exit points.
Now comparing scalping to this strategy, there is less risk involved in scalping as the position is only held for a comparatively short period of time. Using pivot points, you can hold a position for longer durations of the day, where the chances of an unexpected price change are high. However, in this case, with lesser risk come lesser profits. With scalping, as all, you are looking out for are small price movements, any profit you gain is expected to be lesser than what you would be gaining using the daily pivots strategy. How much you can gain using the daily pivots strategy highly depends on the volatility of the stock.
Do note that, as stated before. There are many strategies that exist within day trading, some formally recognized while others aren’t. Comparing scalping to each one of them is beyond the scope of this article; however, the intention of giving you a better idea of scalping is present as a meaningful comparison is given.
4. Advice for Beginners on Scalping
Now, like looking at the state of the digger can tell us a lot about his job, looking inside the minds of scalpers can help you not only learn more about it but maybe even answer the question of whether it is for you or not.
Scalpers are disciplined. They will not hold a position for longer in order to see greater returns despite the high chances of it turning out to be safe. They are already satisfied with the small gains they are making per security as they are dealing in large volumes. They also understand that due to them making very small profits, holding positions for longer can mean exposing what you have gained to more risk. Any sudden price movements can wipe out all profits gained.
They are also quick. Since the price movements, they are dealing with can happen in a matter of seconds to minutes, they need to enter and exit positions very accurately. Hence, they either use computer programs along with Level 2 Quotations and Direct Access Trading.
Final Words
Moreover, as scalpers trade hundreds of times in each session and deal with large volumes ranging from hundreds to thousands, they need to take into account how much they have to pay in commissions. This is where choosing the right broker is crucial. Make a note of only going to brokers who you have spent a good amount of time researching from multiple sources. The broker should have Level 2 Quotations and DAT along with being legit.
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