In the financial marketplaces of the world, there are numerous different styles and trading methodologies employed with the goal of achieving profitability. One of the most prominent forms of trading used by both retail and institutional traders alike is known as “scalping.” Scalping is a trade management strategy in which the trader elects to take small profits quickly as they become available within the marketplace.
Often referred to as “picking up pennies in front of a steam roller”1)Retrieved 16 August 2016 The Black Swan: The Impact of the Highly Improbable, scalping focuses on identifying fluctuations in price during the extreme short-term. Essentially, this trading philosophy is based on the idea that taking small profits repeatedly limits risk and creates an advantage for the trader.
The viability of scalping as a trading approach depends on several contributing factors and inputs:
- Low transaction costs: Commissions and fees need to be minimised in order to facilitate a high-volume approach to trading in a given financial market.
- Efficient market entry and exit: Adequate computer hardware and software technology is required to minimise latency-related slippage and interact within the marketplace efficiently. Slippage on entry and exit can play a major role in the overall profitability of a scalping approach and is magnified when the realised profit per trade is small.
- High volume trade identification: A major part of the scalping methodology is to repeat small profits over and over. It is crucial that the adopted trade recognition philosophy is able to produce a high volume of possible trades.
- High market liquidity: The ability to enter and exit the market quickly and efficiently is dependent upon the number of potential buyers and sellers available at the trader’s desired price. Markets that exhibit a high degree of liquidity, in addition to tight bid/ask spreads, are prime candidates for scalping.
There are several common methods of scalping in which short-term traders attempt to secure market share. Strategies aimed at capturing the bid/ask spread are prevalent in forex scalping, while increased leverage with the objective of harvesting minute moves in price are commonplace in the futures and equities markets.
Advantages Of Scalping
Perhaps the single largest advantage attributed to a trading approach based on scalping methodology is the limited market exposure afforded to the trader. At its core, scalping is an ultra-short-term trading strategy; therefore, the trader (and the equity in the trading account) is only vulnerable to short-term market volatilities. Typically, the short trade durations insulate the trader from greater systemic risks present in the marketplace, and limit the potential liability of each trade.
Another upside is the ability for a trader to profit from rotational or slow markets. While it is true that the most liquid and volatile markets are the primary target of many scalping operations, trading with the goal of capitalising on small market moves can prove to be profitable in stationary markets.
Often, trend or momentum-based trading methodologies struggle when faced with markets stuck in a consolidation or rotational phase. In these market states, fluctuations in price are limited, with the movements in price itself not being robust enough to reach required profit targets. Scalping eliminates the need for a directional market move to realise a profit, because small fluctuations in price are enough to achieve profitability and sustain a scalping approach.
Disadvantages To Scalping
Drawbacks to employing a trading approach based on scalping are numerous and closely related to trader discipline and psychology.
The very nature of scalping is to take small profits quickly in order to limit risk and create a consistent flow of revenue. However, in the pursuit of small profits, the scalper foregoes potentially lucrative trending markets in addition to large and directional pricing moves. In turn, it is possible for a trader to repeatedly “miss out” on trends and generous profits while adhering to the scalping trading plan. Over time, the fear of missing out on these moves can test trader discipline, lead to overtrading, and take a psychological toll on the trader thereby inhibiting performance.
Another drawback to employing a scalping approach is the increased use of leverage. To realise an acceptable profit on a given trade, scalpers often employ large amounts of leverage to boost profit. Trading for small numbers of ticks, pips or points often goes hand in hand with adding several contracts, lots or shares to the trade. Leverage acts as a double-edged sword. In the event a trade is not an immediate success, the potential liability is increased exponentially.
Scalping remains one of the most popular trading methods in the current electronic marketplace. Independent retail traders and institutional investors employ various scalping strategies in pursuit of sustained, long-term profitability. As long as the risks are clearly defined and accepted, and the proper inputs are in place, scalping can potentially provide value and opportunity to nearly any trading operation.
As always, risk is inherent to investment, so forex traders can benefit from conducting their due diligence and/or consulting independent financial advisors before participating in range trading or other strategies.
Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. FXCM will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.
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