What Is Scalping in Trading?
Scalping is a trading style that specializes in profiting off of small price changes and making a fast profit off reselling. In day trading, scalping is a term for a strategy to prioritize making high volumes off small profits.
Scalping requires a trader to have a strict exit strategy, because one large loss could eliminate the many small gainsthe trader worked to obtain. Thus, this strategy must have the right tools—such as a live feed, a direct-access broker, and the stamina to place many trades—to succeed.
Read on to find out more about this strategy, the different types of scalping, and tips about how to use this style of trading.
Key Takeaways
- Scalping is a trading style that specializes in profiting off of small price changes and making a fast profit off reselling.
- Scalping requires a trader to have a strict exit strategy, because one large loss could eliminate the many small gainsthe trader worked to obtain.
- The right tools—such as a live feed, a direct-access broker, and the stamina to place many trades—are required for this strategy to succeed.
- A successful stock scalper will have a much higher ratio of winning trades vs. losing ones, while keeping profits roughly equal or slightly bigger than losses.
- A pure scalper will make a number of trades each day—perhaps in the hundreds.
How Stock Scalping Works
Scalping is based on the assumption that most stocks will complete the first stage of a movement. But where it goes from there is uncertain. After that initialstage, some stocks cease to advance, while others continue advancing.
A discounter intends to take as many small profits as possible. 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. This strategy 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 their trades—it’s just that the wins are much bigger than the losses. A successful stock scalper, however, will have a much higher ratio of winning trades vs. losing ones, while keeping profits roughly equal or slightly bigger than losses.
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 $0.01 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.
Spreads in Scalping vs. Normal Trading Strategy
When scalpers trade, they want to profit off the changes in a security’s bid-ask spread. That’s the difference between the price a broker will buy a security from a scalper (the bid price) and the price the broker will sell it (the ask price) to the scalper. So, the scalper is looking for a narrower spread.
But in normal circ*mstances, trading is fairly consistent and can allow for steady profits. That’s because the spread between the bid and the ask is also steady (supply and demand for securities are balanced).
Scalping As a Primary Trading Style
A pure scalper will make a number of trades each day—perhaps in the hundreds. A scalper will mostly utilize tick, or one-minute charts, since the time frame is small, and they need to see the setups as they take shape as close to real time as possible. Supporting systems such as direct access trading (DAT) andLevel 2quotationsare essentialfor this type of trading. Automatic, instant execution of orders is crucial to a scalper, so a direct-access broker is the preferred method.
Scalping As a Supplementary Trading Style
Traders withlongertime 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 pursue a 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 their 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.
Based on particular setups, any trading system can be used for the purposes of scalping. In this regard, scalping can be seen as a kind of risk management method. 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 their position for a scalp trade at $20 with an initial stop at $19.90, the risk is $0.10. This means that 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 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.
Scalping Strategies
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 because 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 their 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 considered to be closer to the traditional methods of trading. A trader enters a specific amount of shares on any setup or signal from their system and closes the position as soon as the first exit signal is generated near the 1:1 risk/reward ratio.
Tips forNovice Scalpers
With low barriers to entry in the trading world, the number of people trying their hands atday tradingand other strategies, including scalping, has increased. Newcomers to scalping need to make sure the trading style suits their personality, because it requires a disciplined approach. Traders need to make quick decisions, spot opportunities,and constantly monitor the screen. Those who are impatient and feel gratified by picking smallsuccessful trades are perfect for scalping.
That said, scalping is not the best trading strategy for rookies; it involves fast decision making, constant monitoring of positions,and frequent turnover. Still, there are a few tips that can help novice scalpers.
Order Execution
A novice needs to master the art of efficient orderexecution. 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 and Costs
A novice scalper has to make sure to keepcosts in mind while making trades. Scalping involves numerous trades—as many as hundreds during a trading session. Frequent buying and selling are bound to be costly in terms of commissions, which can shrink the profit.
This makes it crucial to choose the rightonline broker. Thebrokershould provide not only requisites—like direct access to markets—but also competitive commissions. And remember, not all brokers allow scalping.
Trading
Spotting the trend andmomentumcomes 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 isa countertrend. But beginners should avoid using this strategy and stick to trading with thetrend.
Trading Sides
Beginners are usually more comfortable with trading on the buy side and should stick to it before they gain sufficient confidence and expertise to handle the short side. However, scalpers must eventually balance long and short trades for the best results.
Technical Analysis
Novices should equip themselves with the basics oftechnical analysisto combat increasing competition in the intraday world. This is especially relevant in today’s markets, which are dominated byhigh-frequency trading (HFT). Also, the majority of trades now takeplace away from the exchanges, indark poolsthat don’t report in real time.
Since scalpers can no longer rely solely on real-time, market depth analysis to get the signals they need to book multiple small profits in a typical trading day, it’s recommended that they use technical indicators that are intended for very small time frames. Three technical indicators are ideal for short-term opportunities: moving average ribbon entry strategy, relative strength/weakness exit strategy, and multiple chart scalping.
One technical indicator that is appropriate for a scalping trading strategy is called multiple chart scalping. First, create a 15-minute chart without any indicators that you can use to keep track of any background conditions that could impact your intraday performance. Then add three lines:one for the opening print, and two for the high and low of thetrading rangethat is set up in the first 45 to 90 minutes of the session. Watch for price action at those levels; they will also set up larger-scale, two-minute buy or sell signals. Your greatest profits during the trading day will come when scalps align withsupportandresistancelevels on the 15-minute, 60-minute, ordaily charts.
Volume
As a technique, scalping requires frequent entry and exit decisionswithin a short time frame. Such a strategy can only be successfully implemented when orders can be filled, and this depends on liquiditylevels. High-volumetrades 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 over 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.
Pros and Cons of Stock Scalping
Advantages
If a trader is able to implement a strict exit strategy, one of the biggest advantages of scalping is that it can be very profitable. Scalpers can leverage small changes in the price of a stock that may not necessarily reflect the overall trend of the commodity’s price for the day.
Scalpers also do not have to follow basic fundamentals because they don’t play a significant role when dealing with only a very short time frame. For this reason, traders don’t need to know that much about the stock.
Another major advantage of this strategy is that there is very little market risk involved. It is designed to limit the losses from any one stock by making tight leverage and stop-loss points. Scalping is also a nondirectional strategy, so the markets don’t need to be moving in a certain direction to take advantage of it—it works when markets are moving up and down. Finally, many scalping strategies are easily automated within the trading system that is being used because they are usually based on a series of technical criteria.
Disadvantages
However, there are also drawbacks to using scalping as a trading strategy.
First and foremost, scalping involves a maximum number of trades compared to other strategies. Opening a large number of trades comes with higher transaction costs because you are paying a commission on every trade. With scalping, you have to take advantage of high amounts of trades to generate enough profit; for some traders, the risk of just generating small profits is not worth it. Some scalpers make dozens or hundreds of trades a day; this strategy can be very time-consuming and requires high levels of concentration.
Pros of Stock Scalping
Can be very profitable if executed precisely and with a strict exit strategy
Many opportunities to leverage small changes in the price of a stock
Do not have to follow basic fundamentals
Very little market risk involved
Nondirectional strategy; can be used if the market is going up or down
Can easily be automated within the trading system that is being used
Cons of Stock Scalping
High transaction costs for participants
Requires greater leverage to make a profit
Can be a time-consuming strategy that requires high levels of concentration
Need to make dozens or hundreds of trades per day to see a profit
Is Stock Scalping Illegal?
Stock scalping is a legal trading strategy. It is used by both retail and institutional investors. However, it can also be used fraudulently, as has been noted by the U.S. Securities and Exchange Commission (SEC), such as when a market participant recommends a stock to cause the price to spike and then sells it at the inflated price to generate profits.
Can You Make Money Scalping Stocks?
Yes, you can make money scalping stocks. Although scalping sacrifices the size of winning trades, it massively increases the ratio of winning trades to losing ones. However, some traders prefer different strategies that allow them to partake in bigger wins.
With scalping, traders take lots of small wins quickly to minimize risk, which means that in pursuit of small wins, they may miss out on bigger wins.
How Do I Choose a Stock for Scalping?
Scalpers typically make trading decisions based on three different factors.
First, they set a target profit amount per trade; this amount is relative to the size of the price of the stock, although most scalpers look for gains in the $0.10 to $0.25 range.
Scalpers also use the Level 2 quotation to follow stocks that break out to new intraday highs or lows in order to capture as much profit as possible. However, to successfully execute this approach, you need to maintain focus for extended periods of time and have the highest level of order execution.
Finally, scalpers trend-spot—follow the news and spot trends that may cause a security to become volatile. This allows them to create a watch list of “hot stocks” that are likely to experience price movements.
What Are Some Scalping Trading Strategies?
There are many scalping strategies.
One strategy is known as marking making. With this strategy, the trader aims to capitalize on the bid-ask spread by putting out a bid and making an offer for the same stock at the same time. This strategy is best employed with stocks that are not showing any real-time price changes.
Another strategy entailsbuying a large number of shares and then selling them for a profit with a tiny price movement. For example, a trader might enter a position for thousands of shares and wait for a tiny price movement to occur. This movement can be as little as a few cents.
A third strategy resembles a traditional day-trading strategy. A trader enters an amount of shares on a system signal or setup and exits the position as soon as a signal is generated near the risk/reward ratio of 1:1. At this point, the profit equals the size of the scalper’s stop. For example, if a trader enters a position at $20 with a stop at $19.90, the risk is $0.10. A risk/reward ratio of 1:1 will be reached at $20.10.
What Is Forex Scalping?
Forex scalpingis a trading style used byforextraders. It involves buying or selling a currency pair and then holding it for a short period of time in an attempt to make a profit. Aforex scalperlooks to make a large number of trades, taking advantage of the small price movements that are common throughout the day.
The Bottom Line
If you are interested in day trading, you should educate yourself about scalping. 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 of why this strategy is popular among many types of traders.
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