We have already stated that scalping is about making small
profits over a long time which can reach significant amounts when combined. But
of course, scalping is not about randomly entering the market and buying or
selling while expecting luck to be on our side. Instead, a successful scalper
is very methodical about both his decisions and expectations from the market.
He aims to combine various unique features of the forex market to create
profitable conditions for trading, and in this sense he aims to exploit the
most basic features of the market for his purposes. Scalping is not only about
exploiting economic events, price trends, and market events, but also the basic
structure, and internal dynamics of the currency market itself, and this is
what sets it apart from other strategies such as swing trading or trend
following.
Exploiting sharp price movements
Many scalpers like to concentrate on the sharp movements
which frequently occur in the currency market. In this case, the aim is to
exploit sudden changes in market liquidity for quick gains later. This kind of
scalping is not very much concerned about the nature of the market traded,
whether prices are trending or ranging, but attaches great importance to
volatility. The purpose is to identify the cases where temporary shortages of
liquidity create imbalances that offer trade opportunities.
In example, let’s consider a typical for traders of the
EURUSD pair. In most cases, spreads are tight, and the market is liquid enough
to prevent any meaningful gaps in the bid-ask spreads. But when, for whatever
reason (often a news shock, but we don’t concern ourselves with the cause
here), liquidity dries out, and a significant bid-ask gap appears, the quote
will be split into two distinct pieces of data: the bid is, let’s say 1.4010,
while the ask is 1.4050. A very short while, the bid-ask spread will narrow,
and the price will gravitate rather hastily to one side. Scalpers use these
very fast fluctuations for making quick profits. Right after the price has
moved up to 1.4030, and the bid-ask spread has narrowed to normal levels, a
scalper may sell, for example, and as volatility takes the price lower to,
1.4020, he closes his short position to open a long one, and so on. The point
is to profit from the emotional reactions of the market by remaining calm, and
betting that behind the sound and fury, there is nothing of significance, at
least for the immediate term.
We’ll discuss this trading method in greater detail while
examining news breakouts. Gaps which can be exploited by scalpers appear most
often in the aftermath of important news releases. The reader can himself open
up the five minute charts of the price action after a non-farm payrolls
release, for example, and observe the many “loops” where the price action
returns to where it began after a series of very severe zigzags. Some scalpers
exploit such periods of emotional intensity for profit in the manner just
mentioned. They will buy or sell just before the release itself, and trade the
sharp, brief swings for a quick profit.
Leverage
Scalping involves small profits compounded over a long time
to generate significant sums. But often the returns from scalping are so small
that even when combined over weeks or months the returns are insignificant for
the amount of effort involved, due to the small size of the actual movements in
the currency market. To overcome this problem, almost all traders involve some
amount of leverage while scalping the forex market.
The level of leverage appropriate for a scalper is a subject
of debate among traders. But in spite of the debate, the most solid advice that
any beginning scalper should heed is to keep leverage as low as possible for at
least the first two, three months of trading. We do not want to take
significant risks while we are still unsure about which strategy we should be
suing while trading. On the other hand, since the scalper is certain to use a
predetermined stop-loss, and not to tamper with it (a scalper doesn’t have that
much time to spend on each individual trade), a leverage ratio that is
inappropriate to slower traders can be acceptable for him. For instance, a
trader whose positions are held over weeks may take a long time before deciding
to exit a position, even if the market is against him for a time. But the
scalper will immediately close a position as soon as the stop-loss level is reached
(and the process is usually automatic).
In short, a higher level of leverage (up to 20 or 50:1) can
be acceptable for traders who open and close positions in very quick
succession, provided that stop-loss orders are never neglected. But there is
still one caveat: in cases like the aftermath of a surprise Fed decision, or an
unexpected non farm payrolls release, spreads can widen instantly, and there
may not be enough time to realize the stop-loss order even with a competent
broker, and losses would be multiplied if high leverage were to be used. To
prevent such outcomes from materializing, it is a good idea to lower the
leverage ratio significantly if we seek to trade market events that can cause
gaps in the bid-ask spread, and create very large volatility.
Scalping Strategies
Although we’ll discuss scalping strategies extensively
later, we need to mention here that scalping requires a considerable command of
technical analysis and strategies. Since one sizable mistake can wipe out the
profits of hundreds of trades taken during a whole day, the scalper must be
very diligent in analyzing the market, and disciplined while applying his
analysis and executing his strategies.
The role of fundamental analysis in scalping is usually very
limited. During the time frames preferred by scalpers, markets move in a random
fashion for the most part, and it is impossible to discuss the impact of a GDP
release during a one-minute period, for example. Needless to say, events
influencing the forex market are not limited to the clustered major releases of
each day. Many scheduled and unscheduled events provide input to the markets
continuously, and as such, even short term movements have some form of
macro-reasoning behind them. However, it is exceptionally difficult for the
retail trader to keep updated with all kinds of news events occurring
throughout the day, and what is more, the markets reaction is itself often
erratic and unpredictable. Consequently, it is difficult to use fundamental
strategies in scalping.
Finally, some traders combine scalping with another approach
such as trend following or range trading and only differ from the pure
practitioners of these strategies in terms of their exposure times. Although
this is a valid approach, the great complexities of adjusting a trend following
strategy to suit a micro-timing trade plan makes this impractical in terms of
both analysis and execution. http://www.forextraders.com
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