What Is Scalping In Trading?
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Scalping in trading refers to a trading style where day traders aim to profit from minimal price changes in underlying assets such as stocks or futures contracts. Due to the small profits per share or contract, it is needed to scalp with high sizes (1,000 shares, 10 futures contracts etc.) and on a high frequency to make meaningful profits.
Due to the high trading volume and exceptionally high trade execution frequency, it is necessary to focus on large-cap stocks rather than small-cap stocks. For this type of trading style, direct access brokers are recommended use since they directly submit orders to the exchange. In contrast, commission-free brokers route their orders to 3rd parties to receive payment for order flow from those venues, which can delay trade execution.
How Scalping in Trading Works
Scalping in trading stands in full contrast to the “limit losses and let your profit run” mentality. A scalper never waits for momentum to unfold and instead takes profits quickly by trailing the stop loss ultra-tight below the entry and latest price. The initial risk-reward ratio is often 1:1, while the quick trail stop movements can increase the ratio to 1:2 and higher in favor of the scalper.
Yet, a scalper needs a good win-loss ratio and a reasonable risk-reward ratio. A win rate of 60% is a good average percentage, and the profitability increases with a good RRR.
So, scalping focuses on high trade frequency, small profits but even smaller losses per trade and a good win-loss ratio.
Scalpers are typically active where high trading volume, tight spreads and increased volatility can be found. That’s typically the case when many retail traders have their entries or stop loss orders. A breakout of the 5-minute opening range, gap and go patterns, and high-momentum stocks during premarket trading are typical setups a scalper is looking for.
The most frequently used tools to identify suitable stocks are stock screeners and stock news apps, which help identify the movement and catalyst of the move. Once a trading signal is identified, everything goes fast from here. The trade entry gets triggered, the stop loss order gets automatically placed, and the profit target order is submitted fast. Within a second or less, everything can be completed, while sometimes, a scalp trade can take 1 or 2 minutes. If it is longer, it is a regular day trade.
Scalpers frequently utilize strategies developed for automated trading purposes to transmit multiple buy and sell orders simultaneously for different asset classes. A trade automation tool helps the trader handle orders with less emotional stress and better accuracy.
Many scalpers use level 2 quotations, tick-based data feeds, and algorithmic trading to define and time their entries. Backtesting software can be used to evaluate profitable strategies in various asset classes. No matter if a trader is day trading stocks, day trading ETFs, or other assets, single variable testing can make a difference in profitability.
Order execution has a high priority in scalping. That’s because the price of what trade is executed is of high importance since risk and reward should stand in a good ratio to each other. Trying to scalp for a 3-cent profit and having an instant slippage of 10 cents just with the trade opening makes it nearly impossible to exit the trade at a profit by simultaneously keeping up proper risk management.
Scalpers make hundreds of trades per day, mainly in the stock market on the Nasdaq or NYSE. Tick charts are the most commonly used chart types, while the order types used depend on the bid-ask spread of the underlying asset. Higher spreads require scalpers to use limit orders to avoid slippage, while small spreads between bid and ask to enable scalpers to use market orders for fast executions.
A scalper trades a lot. Sometimes 100 orders get routed simultaneously to various exchanges. Scalpers focusing on the first 5 minutes of trading can take the rest of the day off, while many continuously monitor the market to identify opportunities to scalp a few additional cents out of the market trading large size once trading volume ramps up.
The trading commissions of a zero-commission broker are $0. Still, those brokers don’t like traders that frequently place orders and might contact you with the request to reduce your order workload, or they will close your account. But even if your broker lets you trade for $0 per trade. Keep in mind that those brokers sell your order flow to venues instead of routing those to the stock exchange. Even with today’s high-speed networks, it can cause a delay in execution, which can end up beneficial.
A direct market access broker is the better alternative since they allow you to define the order route and route the order directly to the desired exchange. Yet, removing liquidity by hitting the ask with a buy order costs around $0.002 per share, which should be considered when calculating profitability. Some exchanges pay earnings in case you add liquidity to the order book at the bid and once the order gets executed. However, using a limit order can end up in a missed trade since an order fill is not guaranteed.
Different jurisdictions have different rules in place for scalpers. Order book manipulation by flashing buy or sell orders intending to fool other market participants is strongly prohibited. You are not allowed to manipulate the order book appearance by placing fake orders without the intent to get them filled. There are various rules in place by the SEC and Finra, and when you get into scalping trading, read all the legal papers first instead of blindly sending 10,000 orders per day after investing 100k in developing your scalp trading systems.
Long vs Short Scalping
Trading volatile stocks with high trading volume on the long side is the main intention of scalpers since every stock can be traded long, and as long as the order book is reasonable with low spreads, it is worth it to consider a stock to go long.
Taking short trades is a bit more difficult for trading on high share sizes since not every stock is on the easy-to-borrow list of a broker. Using a good broker for short selling is better than considering a broker with limited short-selling capacities. Shorting penny stocks to the scalp is a sub-optimal idea since penny stocks are often thinly traded. Therefore, focusing on large-cap stocks trading on high volume with low spreads is the primary target market for scalpers.
Scalping for Beginners
Scalping is an appealing trading style. Investors see the profit potential and conclude that taking many trades for a profit can make them easily make a living from scalping. But things are more challenging than it might appear at the beginning.
Scalping has to fit your trading approach and time capacities. If you have a regular 9-5 job, it’s nearly impossible to scalp while you work. At least if you scalp manually, but even fully automated scalping trading systems require monitoring. The potential problem is that something could go wrong in order transmission, and due to the high number of traded shares or contracts, it is necessary to react and fix things fast.
Also, when considering scalping as a favorite trading strategy, many traders forget that scalpers trade frequently and that the pattern day trader rule comes into effect. This rule requires traders to have a minimum balance of $25,000 in their trading account. Many traders don’t have it and try to avoid the rule with a pattern day trader rule workaround, but those workarounds have their own disadvantages. That means that if you have less than $25,000 available, you better don’t consider scalping as your favorite strategy.
Pros and Cons of Scalping
Scalping can be rewarding if trading strategies are correctly implemented, and entry and exit conditions are followed reliably. Margin account buying power with a leverage of up to 1:4 is typically used for scalping intraday, which enables scalpers to trade more with about 1/4 of intraday margin.
Scalpers don’t care about company fundamentals, so it’s unnecessary to analyze a company’s profitability, EPS, etc. Basically, it is sufficient to identify stocks that trade on high relative volume and high momentum. To identify high momentum, a momentum indicator and momentum scanner can be used.
In addition, technical analysis can be beneficial to identify potential volume spikes in advance. It is a big benefit of scalping that the analysis efforts are relatively small compared to other trading styles and strategies.
Another benefit is that positions are not held overnight. Therefore there is no overnight risk, such as massive price gaps caused by company news or other catalysts. A scalper can always follow the market flow without the need for the overall market sentiment to align with the trend of the specific stock.
Yet, there are some cons to using scalping. First of all, the number of executed trades can be overwhelming for beginners. Many things must be handled simultaneously, and hesitating typically leads to losses. Therefore automation is a big help for scalpers.
In addition, the commissions can add up quickly when liquidity is always taken out of the order books instead of adding liquidity and getting those trades executed. And if you want to avoid commissions by using a $0-commisson broker, you have the potential drawback that the order execution process takes longer.
Finally, the $25,000 account minimum for scalping can be a hurdle for private investors with low funds.
Conclusion to Scalping in Trading
Day traders who know about actively placing buy and sell orders throughout the day consider scalping as a potential add-on trading strategy. In contrast, absolute trading beginners and long-term investors who never traded intraday should be careful when entering this competitive market.
Independently from your experience in the markets, make sure to use a paper trading platform to practice scalping trade techniques. Only those who make a profit on a paper platform or with a stock market simulator should consider trading with real money. After the transition from the simulator to live trading, only a small trading size should be traded to see how the strategy works with real supply and demand in the order book.