Basic Trading Concepts Defined
Here we will take a look at the logic behind scalping, and we’ll discuss the best conditions and necessary adjustments which must be made by a scalper for profitable trading.
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.
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 forex 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.
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 analysing 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 market’s 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.
Reference: Tom Cleveland ©