When we think of day trading, we often imagine scalping, which is a rapid trading style. A scalper can make hundreds of trades in a single day and trade securities in a matter of seconds or minutes for a quick profit. While scalping is considered a lower-risk trading strategy, its high-speed nature makes it harder to get big winners. For those who enjoy seeing massive gains, scalping will be harder to master as the focus is on making incremental gains over time.
- Scalping is a high-speed, high-frequency style of trading that specializes in quick profits through a large number of trades.
- The main focus of scalping is to manage risk and look for opportunities to take advantage of small price changes.
- To be successful in using this strategy, scalpers need to set up a strict exit strategy, have the right tools, and have a focused mindset.
- Initially, scalping may have a steep learning curve as it requires attention to detail, a strong understanding of the market, and depth in technical analysis.
What is Scalping?
Scalping in this scenario is similar to scalpers who make quick profits from reselling concert tickets, limited edition shoes, or the latest game console release. The difference is that scalpers here make incremental profits by rapidly trading securities behind their computers. Compared to other forms of day trading, scalping has the shortest trading cycle. Its name refers to the traders who quickly enter and exit the market to skim, or scalp, small profits.
The goal is to make dozens or hundreds of trades a day on high-volume securities and accumulate a meaningful profit through many small gains. Some scalpers will go in and out of a trade in a matter of seconds, while others may hold a position for five or more minutes. Because of the speed at which they are trading, scalpers rely on markets with large volumes or liquidity. Scalping gets commonly used in the stock market or forex, but it can also get used for options trading, cryptocurrencies, commodities, etc.
Compared to other trading styles, scalping is relatively “safe” because the aim is to exploit trading opportunities, such as a price action of 10 cents per share of stock, versus making a big profit on one risky bet within a longer timeframe. On the flip side, scalpers need to plan strict exit strategies because one massive loss could wipe out all the previous gains.
One way to ensure success is to use the right tools, such as a live feed, direct-access broker, algorithms, etc. A popular tool used by many traders is TradingView, which provides a great community for analyzing markets.
Though scalping is less risky, that doesn’t mean it’s completely risk-free. Scalping may sometimes feel like a marathon as it requires precise timing, prompt execution, and the ability to capitalize on opportunities quickly. As quick as it can be to make a small profit, it’s also easy to lose a lot of money in a short amount of time.
How Does Scalping Work?
For most investors, our mindsets are wired to “let our profits run,” meaning we keep adding to positions where we have profitable trades or investments. However, scalping requires the complete opposite mindset. Rather than increasing the size of winners, this strategy focuses on increasing the number of winners.
The main ideas behind scalping are to lessen exposure to the market and focus on low-hanging fruit.
- The longer we hold onto a position, the more risk we expose ourselves to as the probability of something going wrong increases. There have been many times where I held onto a position for too long and ended up losing more than half of my initial investment. I would have come out of the trade with a sizeable profit if I sold my positions after they hit my price targets.
- For bigger price changes in a security, there needs to be a larger supply and demand imbalance. For example, it’s much more likely for a stock to move 10 cents than to move $20. Rather than focusing on assets with larger price action, exploiting small price movements in tight time windows is much easier to do.
Because of the volume of trades made, a trader may only win half of their trades, or sometimes even less. The key here is to have bigger wins than losses. Scalping hundreds or thousands of shares of stock at a profit of pennies can still add up to hundreds of dollars in gains on a single trade. However, a successful scalper will likely have a high win ratio and keep profits bigger than losses.
As mentioned earlier, scalping requires sacrificing the possibility of larger gains, which takes discipline. Once your profit target gets hit, you are out. That means not waiting an extra minute or hour to see if you can profit more from a trade. The same goes for losing trades – once your target loss level gets hit, you should exit.
To define the target profit and loss levels, scalpers often will take a 1-to-1 trading mindset approach. That means the trader will accept equal gains and losses. For example, if you want to trade a penny stock that costs $5 per share and set a price target of $5.15, you will accept the $0.15 risk or reward. If the price hits $5.15, you will exit with your gains. If the price drops to $4.85, you accept the loss and exit. For the most part, the range will be very narrow.
Spreads on Scalping vs. Normal Trading
Under normal circumstances, the supply and demand for securities balance out, meaning the bid-ask spread is steady. That translates to fairly consistent trading and steady profits. When scalpers trade, they exploit changes in a security’s bid-ask spread, meaning they look for narrow spreads.
Daytrading vs. Scalping
Scalping is a type of day trading, but not all day trading is considered scalping. As such, traders must follow the pattern day trading rules set by FINRA (Financial Industry Regulatory Authority). The most important rule is that traders who want to make four or more trades in five business days must have a minimum balance of $25,000. If you get flagged as a pattern day trader and do not have enough funds, your account may get restricted for 90 days or until the minimum equity margin call is met.
The main difference between traditional day trading and scalping is the timeframe. While both types of traders will close out positions at the end of the day, scalping takes trading to another level. With day trading, traders can hold a trade for hours at a time to see it play out. Meanwhile, with scalping, win or lose, traders will exit their positions once their target levels get hit.
A couple of other differences to note are the position size and volume of trades for scalping compared to day trading. Scalpers usually trade larger volumes and use more leverage to maximize gains. Because the profit margins are so tiny on each trade, it is necessary to have huge volumes for this strategy to yield decent profits. Most day traders are warned not to overtrade. But with scalping, this is a must if you want to be successful. Hence, more experienced traders tend to scalp rather than day trade.
If you can’t decide between traditional day trading or scalping, take some time to think about your risk profile and objectives. Depending on your answer, one strategy is better suited for you than the other one.
Why Use Scalping?
In addition to minimizing exposure to risk and focusing on small wins, other reasons traders are attracted to scalping are because of the control they have and the number of trading opportunities.
With scalping, you eliminate the influence of emotions, such as fear or greed. One of the biggest reasons why day traders fail is because they let their emotions take over. Staying controlled and disciplined is something that I still struggle with quite often. It’s not easy to let go of a trade when its price is running up because I want to see how it will play out and whether I can make more money. Likewise, it’s hard to pull out of a losing trade because it requires admitting that I was wrong.
The good news is that you have a large number of trading opportunities when you scalp. If you make a losing trade, just brush it off and move on to the next trade. You have plenty of chances to try again until you succeed.
Scalping as a Primary vs. Secondary Trading Style
Depending on how you incorporate scalping into your trading strategies, they will require different setups.
Primary Trading Style
If you only scalp, you will likely be making many trades each day using tick, or one-minute time charts. Because the success of each trade depends on how fast your orders get executed, the timeframe will be tight, and the setups will need to be as close to real-time, or instantaneous, as possible.
A couple of tools you can use to support your trading strategy include Direct Access Trading (DAT) and Level 2 data. DAT is the preferred system for day traders because it cuts out the middleman. Rather than having a broker interfere, DAT is a technology system that allows traders to trade directly with a market maker on Nasdaq or a specialist on Wall Street or another exchange. With Level 2 data, traders can create more complicated setups using market depth, such as liquidity, order sizes, top bid and ask orders, and more.
Secondary Trading Style
If you prefer trading with longer timeframes, scalping can get used as a secondary trading style. An example would be scalping when the market is choppy, meaning the prices are swinging up and down with no visible trend, or when the market is locked in a narrow range, meaning the lows and highs are closely tied together.
Another strategy is through the “umbrella” concept, where a trader has the flexibility to improve their cost-basis and maximize gains. To do this, a trader will open a position with a longer timeframe, and while waiting to see what happens to that trade, they will find new setups with shorter time frames to scalp that align in the direction of their main trade.
Systemic vs. Discretionary Scalpers
There are two types of trading strategies scalpers can use – discretionary trading and system trading. Both have the same goal, which is to make as much money as possible. However, they take different approaches to reach that goal.
Discretionary scalpers make trading decisions based on current market conditions. That means they decide the parameters, such as the entry point, exit point, timing, etc. The idea here is that discretionary traders have complete control over all the decisions needed to execute an order.
On the other hand, system trading relies heavily on rules and ignores current market conditions. Rather than relying on instinct, systemic scalpers use algorithms to conduct trades based on predefined criteria. When a trading opportunity arises, it will automatically execute without needing the trader’s discretion.
While both systems can be profitable, there are a few downsides to note. With discretionary systems, traders will be exposed to trader psychology, meaning their emotions can lead to bad trades or failure to take advantage of an opportunity. Systemic scalping takes the emotions out of trading, but the trades are absolute, so they are not adaptive to current conditions. If the market conditions are not favorable, a trade may still take place if the initial criteria are met.
Depending on your personality, one will be more suitable for your trading strategy. If you don’t fully trust algorithms and want to stay in control over the trading process, then discretionary trading is better for you. If you prefer speed, accuracy, and precision rather than control over the trading process, go for system trading.
3 Types of Scalping Strategies
Three main types of scalping strategies you should pay attention to include:
- Market making – With this strategy, a scalper will try to capitalize on the bid-ask spread of a specific security by simultaneously posting a bid and an offer. For this to succeed, the securities must have large volumes and are trending flat. While this can lead to quick profits, it’s difficult for retailers like us to pull off because we will be competing against market makers for shares on both sides. Additionally, the potential profit is so tiny that any price movement against our position will lead to a loss.
- Large lot trading – A more traditional and straightforward approach is large lot trading. With this style, a trade will purchase a security in bulk and sell it at incremental gains. For example, a trader will buy a few thousand shares of a stock, wait for a slight price movement (i.e. a few cents), and exit with the gains. Large lot trading requires securities with high liquidity, as you could be buying 10,000 shares or more at a time.
- Exit trading – The most traditional method of trading between these three is exit trading, which is when a trader exits a position as soon as they get the first exit signal generated near the 1:1 risk-to-reward ratio we mentioned earlier. The goal is to hedge against further market moves beyond the 1:1 ratio, so traders will disregard previous price tolerances and exit even if they don’t make any gains.
With market making, a trader relies heavily on the prices of security to stay put. Meanwhile, with large lot trading and exiting trade, both styles require rapidly changing price action and a strong understanding of how to read market movement.
Tips and Tricks for Beginners
These days, anyone can open an investment account and start trading. Particularly with the rise of commission-free trading, the barriers to entry are lower than ever before. With that in mind, beginner scalpers need to make sure they are equipped with the right tools and mindset to scalp successfully. Scalping requires a disciplined approach to trading, including making quick decisions, staying focused, and spotting opportunities.
Still, there are a few tips and tricks that newcomers to scalping can leverage to their advantage.
To be a successful trader, you need to have an efficient process for order execution. Because the profit margin for each trade is so minuscule, the orders have to get executed swiftly and accurately. If a trade gets delayed or you make a mistake, you could wipe out all the profits you’ve earned.
Frequency and Costs
Pure scalping involves making upwards of hundreds of trades in a single trading session, so it’s crucial to keep costs in mind. While most investment platforms have little to no commissions nowadays, even small fees can add up. That’s why choosing the best available brokers or exchanges will play a significant role in your profitability. Some prerequisites include competitive commissions, direct access to markets, and the ability to scalp since some brokers don’t allow scalping.
To trade successfully, you need to understand the markets, including identifying trends and countertrends, momentum plays, patterns, etc. If you can identify key patterns in a stock’s price action, for example, then you can repeat the patterns and enter and exit multiple times.
Most beginners stick to trading on the buyers’ side when they first start out. Once they gain more confidence and expertise, they start trading on both the long and short sides. For the best results, scalpers should learn how to balance both ends of trading.
Trading is becoming increasingly competitive, particularly with high-frequency trading (HFT) and dark pools in the background. That’s why it’s crucial to understand the basics of technical analysis. Technical analysts take a deep dive into the markets to find the signals they need to create their setups. This process includes using technical indicators and patterns such as candlesticks, multiple chart scalping, moving averages, VWAP, etc.
This trading style differs from fundamental analysis, which focuses on finding the intrinsic value of a security. For example, in the context of the stock market, this would include data from a company’s financial statements, economic and political conditions, market sentiment, etc.
Traders need to get the best prices possible and move in and out of trades with ease to scalp successfully. That means orders need to get filled quickly, which depends on liquidity and volume. The more liquidity and higher volume there is, the better.
Risk management is a crucial part of scalping. As a rule of thumb, scalpers should close all their positions at the end of the day, in addition to setting stop losses and taking profits once price targets get hit. More experienced scalpers use a 1% rule, where they will not open a position that is more than 1% of their account balance to minimize risks.
Algorithmic trading, which gets commonly referred to as expert advisors, is a great way to automate your trading. As a retail investor, competing against hedge funds or large banks with teams to build algorithmic programs for them is difficult. Rather than manually making every trade yourself, having a tool to ease your burden can increase your profits.
Advantages and Disadvantages of Scalping
Pros of Scalping
If you learn how to scalp with precision, you can make a lot of money. Once you set a strict exit strategy and incorporate algorithms or advanced trading tools into your trading strategy, you’ll be able to stay on top of your game. A nice part about scalping is that you can take advantage of price actions that do not reflect the overall market sentiment at that moment.
Unlike fundamental analysis, which requires a lot of research, scalping is pretty intuitive. Once you develop the discipline and skills to trade, you do not need to keep up with what’s happening in the markets or follow fundamentals. With long-term investing, you have to understand what you are investing in and keep up with what’s happening in the market. With scalping, you don’t need to know much about the security to trade.
One advantage of scalping is that there is little risk involved. By design, scalping is supposed to limit your loss potential, which is why experts recommend setting up strict rules regarding price targets and time frames. In addition, scalping works regardless of which direction the market is moving. That means you do not need to rely on the price of a security to move in a specific direction to make money. You can play both sides.
Because the focus is on smaller movements in the market, that gives you more opportunities to make a move. Even if the market is quiet, you can still take advantage of any small change in the price of a security.
Scalpers can use margin to leverage their trades and open bigger positions than they can afford. That means scalpers can borrow money to increase their account balance to make even more money. Depending on the investment platform used, you can raise your purchasing power by more than 50%, dramatically increasing your profit potential.
Cons of Scalping
With scalping, not every trade will be a winner, so the focus is on maximizing the number of trades you can make. For some traders, this process may not be worth it for the total gains they make.
High transaction costs
For scalping to yield decent profits, traders need to find investment platforms with competitive commissions. Even though Robinhood often touts itself as a commission-free platform, it has many hidden fees that may end up costing investors more than what they realize. In early 2021, Robinhood was sued for breaching its “duty of best execution.” In other words, Robinhood was not necessarily giving its users the best available rates, even though on paper, the platform was free.
On the flip side of leverage, there is a possibility of losing a lot of money if you make the wrong trades. The more money you borrow, the more risk you expose yourself to if something goes wrong.
Scalping requires a high degree of concentration, which can become very demanding over time. You can’t just make a few winning trades and then call it a day an hour or two into your trading session. You have to keep up with anything that can trigger price movements, such as current news, momentum, trends, etc.
Like with any investment, you are not guaranteed to make money. If you are considering incorporating scalping into your trading strategy, this is something to keep in mind.
The Bottom Line: Is Scalping the Right Strategy For Me?
Compared to other forms of investing or trading, scalping requires a high level of attention to detail and discipline. For beginners, there may be a steep learning curve. Scalping requires a relatively technical background and access to market depth. If you want to get rich overnight, this is not the right strategy for you, as scalping is no walk in the park.
Before jumping into scalping, think about what trading style you prefer and how much effort you want to put into trading. Scalping is all about enjoying the small wins and gradually building your wealth.