On an old Saturday Night Live sketch, a fake ad aired for First Citywide Change Bank, a bank that only made change for its customers. “If you have a $10, we’ll give you two $5’s,” the bank manager says. “How do we make money doing this? The answer is simple: volume.”
Of course, this is a play on the old retailer joke about selling at a loss and making it up on volume. If you don’t profit or only break even on every trade, no amount of volume in the world will help you. But even a small profit margin can produce successful results – you just need to make it up in volume.
In trading, scalping is a method that involves taking lots of little profits on a large number of trades. In theory, these little profits build up to large gains over time, as long as the trader sticks to their strategy consistently. But scalp trading is often a tedious and demanding way to trade – you need to monitor stocks tick by tick and be prepared to enter or exit a position at a moment’s notice.
What is Scalping?
Like the ticket scalpers at football games, stock scalpers aren’t looking for big scores. Instead, they attempt to profit off minor gains dozens or even hundreds of times per day. In forex markets, scalpers often profit off the bid/ask spread. The ask is the highest price a buyer will accept for a security while the bid is the lowest price a seller will accept for that same security. Currency traders utilize a scalping technique to profit off the difference in the spread by buying at the bid and selling at the ask, profiting off the difference in the spread.
Stock traders can also profit off differences in bid/ask spreads, but it requires lightning-fast trade execution and large amounts of capital. If you don’t have a direct market access broker and sophisticated trading technology, you likely can’t compete with the big boy on bid/ask scalping. However, scalping is still an effective strategy for day traders looking to take profits off small ups and downs in equities.
Scalping is often difficult because it goes against some of the most hardened investment philosophies. New investors often hold on to losers too long trying to break even while selling winners too early. Letting winners run while cutting losers early is a mindset that must be ingrained. But scalpers? They cut losers AND winners quickly, not caring what the stock does after profit (or loss) targets are reached.
If a scalper puts a 5% profit goal on a trade and the stock immediately shoots up 5%, the trade is exited. What happens if the shares continue to go up? That’s of no concern to the scalper, who has already moved on to the next trade. Traders utilizing scalping techniques need short memories and quick trigger fingers, which is why this type of trading isn’t for everyone.
How Scalp Trading Works
Scalpers look for highly liquid stocks with low spreads and ample shares available. Since scalpers are looking to profit off small moves, a large amount of capital is needed for most trades. Traders can often scalp the same stock in both directions numerous times in the same session if the shares are volatile and conditions are right.
Here’s an example of a scalp trade. Shares of AMC have been trading at high volume recently, providing traders with plenty of scalping opportunities.
On March 8th, the stock was particularly volatile and traders could have jumped at this trade here. Around 11:17am, the 5-day EMA crossed below the 10-day EMA, a common bearish signal amongst day traders. At this point, a short entry can be made at $9.25 with a profit target of 3%. When the shares decline to $8.97, the profit target of 3% is reached and the position is immediately exited.
Types of Technical Indicators to Use for Scalp Trading
Scalping takes place over too small a timeframe for fundamental analysis like earnings or margins to be of any interest. Technical trading signals are the weapon of choice for scalpers. Here a few critical ones to familiarize yourself with.
- Moving averages – Used frequently in all types of data charts, moving averages put random price data into a uniform path in order to help traders better plot their moves. Simple moving averages use the average price over a specific period of time; exponential moving averages give recent price data more importance.
- Bollinger bands – Developed by trader John Bollinger, Bollinger Bands are plotted by taking a stock’s 20-day moving average and moving out one standard deviation to the upside and one standard deviation to the downside. When share price reaches the top Bollinger Band, an overbought signal is sent. And an oversold signal is sent when the lower Bollinger Band is reached. Technical indicators like MAs and Bollinger Bands are important to scalpers who are looking for clear, defined signals to enter and exit their trades.
Pros of Scalping
- Low risk – Scalpers don’t tolerate losses. When you’re looking for quick moves, you can’t keep your loss limits at their most modest levels – like 0.5% or less. Scalpers might put a lot of capital behind their trade, but unless shares are halted in the short window the position is open, losses will be cut quickly.
- Profitable in any market condition – Momentum traders struggle in flat markets. Bulls struggle when markets are down. Bears struggle when markets are up. But scalpers can profit in all three of these scenarios because the larger trend and macroeconomic data points are irrelevant. If a liquid stock has a daily range of 1-2%, then a scalper can profit from it.
Cons of Scalping
- Labor of love – Scalp traders need to make lots of trades over the course of the day so their small profits can add up to big overall gains. This means a lot of time spent staring at screens, analyzing charts, and combing through scanners looking for potential securities to scalp.
- No big wins – Scoring a large profit thanks to a big earnings beat, FDA approval, or some other catalyst is one of the purest joys an investor can get. If you’re a scalper, you don’t get to experience these feelings. Your wins are always small, even if the stocks you buy head towards the moon. Do you have the mental fortitude to forego large gains and stick to your scalping plan?
- Capital intensive – If you’re looking to make it as a scalper, you’ll need to put large sums of capital behind your trades. In the hypothetical AMC trade discussed above, we shorted at $9.25 and covered at $8.97. That’s only 28 cent profit per share, so even a 1000 share trade only nets $280 in total. Every penny is precious when using scalping strategies, so you’ll need liquid securities, cheap borrowing rates, and lots of capital to throw around.
Scalp trading is an easy technique to learn, but a difficult one to master. You need to be mechanical and emotionless when scalping stocks, entering and exiting trades using precise controls and forgoing large gains. You don’t need to learn complex technical analysis or use derivatives like options and futures contracts to scalp, but you’ll need to ace a few key concepts and strictly follow your trading rules.
If trading is an emotional venture for you, scalping is probably a strategy to avoid. The best scalpers are like robots, buying and selling shares like an algorithm with no memory of the past or care about the future. In fact, automated trading systems are often programmed to scalp stocks based on predetermined inputs. If you have access to direct market brokers and automated trading systems, scalping can be a very effective strategy. If you’re day trading on your smartphone, it’s going to be a lot harder to make profits. But if you stick to your plan and act without emotion, scalping can be a nice thing to add to your trading repertoire.
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