If you're the type of investor who likes to grab a small profit fast and move onto the next opportunity, then you might consider scalping as a trading strategy. Scalping involves making quick trades on small timeframes, cashing out the position as soon as it becomes profitable, and then repeating the strategy again and again. There are various ways to scalp stocks, and each method comes with a different level of risk.
Let Your Profits Run?
The usual investing mantra is to "let your profits run." The expression is designed to encourage investors to hold onto winning positions and resist the urge to sell them too early. On the surface, this seems like good advice. When you get on the right side of a trend, you have the potential for making serious wins as long as you don't back out of the trade too soon.
The problem here is that trades don't always stay in profit. Most will complete the first stage of a movement, but after that, some wins will stagnate, some will evaporate, and some will continue to advance. For traders with a longer time frame, it's not unusual to win only half of their trades and lose the rest. To make money, they just have to hope that the wins are much bigger than the losses.
Small Profits Add Up
A scalper adopts the opposite mindset: He does not let the profits run. Instead, he takes as many small wins as possible and gets out fast before the trade can turn against him. Scalping sacrifices the size of the wins but massively increases the ratio of winning trades to losing ones.
Here's the scalping mantra, in a nutshell:
- Take fast moves for fast gains.
- Make dozens or even hundreds of trades per day.
Accept a tiny profit position
with stock scalping, for instance, a trader might close a trade with a less than 1 percent move. * Get in and out of trades quickly –
a scalp investor may spend just 1 or 2 minutes in the market. Typically, she will close all positions on a day's trading and not hold them overnight.
Scalping Stocks: Pros and Cons
Scalp trading focuses on identifying price fluctuations in the extreme short term, with trades held for less than a minute in some cases! So it requires quite a lot of discipline on the part of the trader and is not a strategy that suits everyone. Before we get into the how of scalping, it's worth looking at the why. Advantages of scalping include:
- Limited market exposure. Scalping is an ultra short-term trading strategy, so you are only vulnerable to short-term market fluctuations. For the risk averse, it's a good way to avoid making a big loss on a trade.
- Profit from a slow market. Scalping aims to profit from extremely small market moves so that there's the potential for profit even if the market is slow or stationary. You only need the market to move a percentage point to make a profit.
- Not getting stuck in a reversal. Stocks may trend in one direction and then reverse right back again. Scalpers get out before the position reverses.
- A higher win rate. Because you are capitalizing on short-term moves, your win rate should be higher. Successful scalpers aim for a win rate of around 80 percent on all trades.
- Very little trading capital required. Scalping can bring in small, regular profits as you don't have to wait weeks before you close a profitable trade.
The disadvantages of scalping include:
- Missing out on big wins. The whole point of scalping is to take lots of small wins quickly to minimize risk. But in pursuit of small wins, you could be trading for crumbs and not the "meat" of the market.
- Being hard to predict. Scalping requires you to predict what's going to happen on a minute-to-minute basis, and this is really tough to do consistently. You have to enter at exactly the right time on the right entry price, and exit at exactly the right time too.
- Being psychologically exhausting. Unlike with long-term trading where you need only one big win to accumulate a decent return, scalpers must win consistently over multiple positions in order to be profitable. Scalpers must be glued to their monitors, waiting for the slightest move to pounce on a position, which can be exhausting. You must be able to control your emotions and stick to your strategy.
- Commissions that add up. The sheer volume of trades means commissions will soon add up. High-volume scalp trading is not viable unless you can minimize fees and commissions through a broker dealer.
Tools of the Trade
Not every brokerage firm permits scalping, and some that do might require that you to scalp in a "non-aggressive" style. This means scalping as a supplementary style of trading, alongside some longer-term positions. Look for a broker that will permit you to hold positions for mere minutes, and use tight stop-loss orders on them.
Read the small print carefully and make sure you're not being restricted through trade number limits or additional commissions. Even a low flat commission rate of $2 per trade would render the exercise of scalp trading unprofitable.
Make sure that you have fast and reliable internet connection – scalping is not something you want to do over the mobile phone network. You must be able to close a trade the moment you reach your profit goal even if takes five seconds. You must be able to see the setups in real time.
It's essential that your broker has a Level 2 (Level II) quote system or Direct Access Trading that automatically tracks bids and asks, so you can enter and exit efficiently. Slippage on entry/ exit timescales can impact the profitability of scaling since one slow exit could eliminate the entire gains. Master the art of flawless order execution before you begin.
A Primer on Bid-Ask Spreads
There are a great number of scalping strategies that exist for a wide range of trading products – stocks, bonds, binary options, commodities, forex and so on. Fundamentally though, what you're trying to do is identify bid-ask spreads that are a little wider or narrower than normal due to temporary imbalances in supply and demand.
The bid-ask spread is the difference between the price that a broker will buy a security for (the bid) and the price that the broker is charging investors who want to buy it (the ask). For example, if the bid price for a stock is $25 and the ask price $26, then the bid-ask spread for the stock in question is $1.
Three Basic Scalping Options
The first scalping strategy is known as market making. Here, the scalper aims to capitalize on the bid-ask spread by putting out a bid and making an offer for the same stock simultaneously. Market making works best with stocks that are largely immobile, meaning they're not showing any real-time price changes. This is a tough strategy for novices as you'd be competing with the market markers on offers as well as bids.
Another strategy involves buying a large quantity of shares, then selling them for a profit with a tiny price movement. For example, a scalper will enter a position for thousands of shares and wait for a tiny move to happen – often, this is just a few cents. Since you need to hit your targets fast and repeatedly, it's crucial that you look for stock with good liquidity and a significant daily trade volume (perhaps a million or more shares). This ensures you get the best price you can when getting in out and out of the trades.
The third strategy looks a lot like traditional day trading. A scalper 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. This means the profit has equaled the size of the scalper's stop. For example, if a scalper enters a position at $15 with a stop at $14.90, the risk is 10 cents. A risk/reward ratio of 1:1 will be reached at $15.10.
How Will You Make a Trading Decision?
Scalpers make trading decisions based on these factors:
- Setting a target profit amount per trade. The goal you set should be relative to the price of the stock. Most scalpers look for gains in the 0.10 to 0.25 cent range; remember that you'll need a high win/lose ratio for these tiny profit margins to work.
- Using the Level 2 quotation to track stocks breaking out to new intraday highs or lows to capture as much profit as possible. To be successful with this approach, you will need an enormous amount of focus (no bathroom breaks!) and the highest level of order execution.
- Trend spot. Follow the news and spot trends that may cause a security to become volatile, creating a watch list of "hot stocks" that are likely to experience price movements.
Playing With Very Small Numbers
Once you have selected a strategy and a target, you'll need to buy enough stock so that a tiny 5 or 10 cent movement will give you enough profit to close the trade. Don't be tempted to go big or you will wind up playing a different trading game.
Here's an example: Suppose it would cost you $1,000 to buy 100 shares at $10 a share. If the price swings upwards 10 cents to $10.10, you would be set to make a $100 profit before commissions. Assuming the gain falls in your target profit range, you'd close the trade, go back to your stock chart and wait for the next scalping opportunity.
Winning at Scalping Stocks
While it sounds simple enough, scalping strategies are not easy. Here are some guidelines for the novice scalper to keep in mind:
- Start on the buy side and get comfortable there before you go on to the short side (selling first then buying later).
Practice with small sums
– it takes a while to get efficient in executing orders. Be ready to execute your order the second you choose the trade. Even a small delay can eat whatever profit there may have been. Don't leave positions open at the end of the day's trading. Since scalping relies on exploiting small opportunities, it's wise to not carry positions over to the next day.
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- Keep careful accounting records of each trade so you can accurately file your income tax return.
- The Securities and Exchange Commission considers stock scalping very risky. Only trade with money you can afford to lose.
Jayne Thompson earned an LLB in Law and Business Administration from the University of Birmingham and an LLM in International Law from the University of East London. She practiced in various “big law” firms before launching a career as a commercial writer. Her work has appeared on numerous financial blogs including Wealth Soup and Synchrony. Find her at www.whiterosecopywriting.com.