Traders use many different strategies to generate above-market risk-adjusted returns.
Many novice short-term traders forget about the “risk-adjusted” part and gamble on volatile low-priced stocks, but experienced traders know that risk management is just as important as high returns.
Scalping is one of the most common strategies used by short-term retail and institutional traders. Rather than optimizing for a big gain from a single trade, scalping optimizes the win-to-loss ratio across many trades. The process involves quickly booking small profits and losses as they appear in the market.
Check out this article to learn more about scalping.
Pros and Cons of Scalping
Traders should carefully consider the pros and cons of scalping before using the strategy.
The benefits of scalping include:
- Limited Risk: Scalping strategies are designed to limit the risk of loss from any single trade by creating tight take-profit and stop-loss points. There’s very little market risk.
- Non-Directional: Scalping is a non-directional strategy that doesn’t require the market to move in a specific direction. You can profit in both up and down markets.
- Easy to Automate: Scalping strategies are often easy to automate with trading systems since they are usually based on a series of technical criteria that can be computed.
The drawbacks of scalping include:
- Higher Minimums: Scalping requires higher minimum account values to either comply with pattern day trading rules ($25,000) or generate enough profits to reach your goals.
- Higher Transaction Costs: Scalping involves placing a greater number of trades than other strategies, which means that transaction costs tend to be much higher.
- Greater Leverage: Scalping often requires a high amount of leverage to generate enough profit, which makes it very important to control for risk to avoid large losses.
Scalping is best for short-term traders with access to sufficient starting capital. A high level of discipline is also required for scalpers that aren’t using automated trading systems to buy and sell equities, currencies, or futures. And finally, it’s important to backtest and paper trade any untested scalping strategy to ensure it’s the right fit for your goals.
Popular Scalping Strategies
There are countless different trading strategies that can be used for scalping profits.
It’s important to note that these strategies cannot be blindly implemented to scalp profits in any asset; rather, they serve as a starting point to developing a more fine-tuned strategy for a particular asset.
There are several steps to implementing scalping strategies:
- Define: Determine what technical indicators you plan on using and the settings for them.
- Backtest: See how the strategy would have performed in the past using historical data.
- Paper Trade: Paper trade the strategies using your broker and level II quotes.
- Optimize: Make any necessary improvements to the strategy to improve the risk-adjusted returns.
- Trade: Trade using the strategy and carefully track the results, while being cognizant of any market-moving news.
To know more about different technical indicators, click here.
Here are two common strategies and examples of their usage:
Moving Average Ribbons
The most basic strategy for scalping involves the use of multiple moving averages. Short-term moving averages are often used to generate buy and sell signals when they cross above or below long-term moving averages. Moving average “ribbons” can be created using a series of equally spaced moving averages – oftentimes, a large number of moving averages.
In the chart above, we create a series of moving averages, from the 8-day to the 60-day, and plot them all on the same chart of the S&P 500 SPDR (SPY) to create a moving average ribbon. A long position is entered when all of the moving averages cross above the 60-day and a short position is created when the 8-day crosses below the 14-day moving average. The short-term moving average can also serve as a stop-loss point to limit risk.
Stochastics with Bollinger Bands
The Stochastic Oscillator is a popular momentum indicator that shows the location of the closing price relative to its high and low prices over a given period of time. On the other hand, Bollinger Bands® are used to show volatility over a period of time. These two technical indicators are often combined to identify scalping opportunities over short periods of time.
In the chart above, the Stochastics Oscillator and Bollinger Bands are plotted on a chart of the S&P 500 SPDR (SPY). A buy signal is generated when the price hits the low end of the Bollinger Brand and the stochastics experience a bullish crossover. A sell signal is generated when the price hits the top of the Bollinger Band and the stochastics experience a bearish crossover. The Bollinger Band can also serve as a valuable stop-loss point to limit risk on the trade.
The Bottom Line
Scalping has become one of the most popular short-term trading strategies used by both retail and institutional traders, and for good reason: it’s a relatively low-risk strategy that works in any market conditions. However, when developing a strategy, it’s important to backtest and paper trade it to ensure that it produces the expected results and is the right fit for you.