Today we are going to cover one of the most widely known, but misunderstood strategies – scalp trading, a.k.a scalping. If you like entering and closing trades in a short period of time, then this article will definitely suite you best.
Scalp trading Definition
Scalp trading is one of the most challenging styles of trading to master. It requires unbelievable discipline and trading focus. Scalp trading has been around for many years, but has lost some of its allure in recent times. Traders are attracted to scalp trading for the following reasons:
- less exposure to risk
- you can place up to a hundred trades or more per day
- ability to fight the greed, since your profit targets are very small
- greater number of trading opportunities
Years ago when stocks were quoted in fractions, there was a standard spread of 1/16 of a dollar or a "teenie". This spread allowed scalp traders to buy a stock at the bid and immediately sell at the ask. Hence the teenie presented clear entry and exit levels for scalp traders. The scalp trading game took a turn for the worst when the market converted to the decimal system. The decimal system closed the "teenie" often times to within 1 penny for high volume stocks. This overnight shifted the strategy for scalp traders. A scalp trader now had to rely more on their instincts, level II, and the time and sales window.
How to Scalp Trade
A scalp trader can look to make money in a variety of ways. One method is to have a set profit target amount per trade. This profit target should be relative to the price of the security and can range between .%1 - .25%. Another method is to track stocks breaking out to new intra-day highs or lows and utilizing Level II to capture as much profit as possible. This method requires an enormous amount of concentration and flawless order execution. Lastly, some scalp traders will follow the news, and trade upcoming or current events that can cause increase volatility in a stock.
Winning is Critical
Unlike a number of day trading strategies where you can have a win/loss ration of less than 50% and still make money, scalp traders must have a high win/loss ratio. This is due to the fact that losing and winning trades are generally equal in size. The necessity of being right, is the primary factor scalp trading is such a challenging method of making money in the market.
Now that we have covered the basics of scalping, let’s explore a few trading strategies you can test for yourself.
Scalp Trading with an Oscillator
One of the most attractive ways to scalp the market is by using an oscillator as the indicator leads the price action.
Yes, it sounds pretty simple; however, it is probably one of the hardest trading methodologies to nail down.
Since oscillators are leading indicators, they provide many false signals. The reality is that if you scalp stocks with one oscillator, most likely you are going to accurately predict the price action 50% of the time.
Literally the equivalent to flipping a coin.
While 50% may prove a profitable ratio for other strategies, when scalping, you need a high win to loss ratio due to the increased commission costs.
Let’s dig a little deeper.
Scalp Trading with the Stochastic Oscillator
The slow stochastic consists of a lower and an upper level. The lower level is the oversold area and the upper level is the overbought area. When the two lines of the indicator cross upwards from the lower area, a long signal is triggered. When the two lines of the indicator cross downwards from the upper area, a short signal is generated.
The below image further illustrates these trade signals.
This is the 5-minute chart of Netflix from Nov 23, 2015. At the bottom of the chart, we see the stochastic oscillator. The circles on the indicator represent the trade signals.
In this case, we have 4 profitable signals and 6 false signals. The 4 profitable signals generate $2.40 per share of Netflix. However, the losses from the 6 false signals generate a loss of almost $3.00 per share.
You are probably asking yourself, what went wrong?
The bottom line is the stochastic oscillator is not meant to be a standalone indicator. You need some other form of validation to strengthen the signal before taking a trading opportunity.
Scalp Trading with Stochastics and Bollinger Bands
In the next trading example, we will combine the stochastic oscillator with bollinger bands.
We will enter the market only when the stochastic generates a proper overbought or oversold signal that is confirmed by the bollinger bands.
In order to receive a confirmation from the bollinger band indicator, we need the price to cross the red moving average in the middle of the indicator. We will stay with each trade until the price touches the opposite bollinger band level.
Above is the same 5-minute chart of Netflix. This time, we have included the bollinger bands on the chart.
We start with the first signal which is a long trade. Notice that the stochastic generates a bullish signal. However, the price does not break the moving average on the bollinger band. Therefore, the signal is false.
The second signal is also bullish on the stochastic and we stay long until the price touches the upper bollinger band.
At the end of this bullish move, we receive a short signal from the stochastics after the price meets the upper level of the bollinger bands for our third signal. A price decrease occurs and the moving average of the bollinger bands is broken to the downside. We have a short signal confirmation and we open a trade.
The fourth trade provides a long opportunity after the selloff.
The stochastic generates a bullish signal and the moving is broken to the upside, therefore we enter a long trade. We hold the trade until the price touches the upper bollinger band level.
As you can see on the chart, after this winning trade, there are 5 false signals in a row. Talk about a money pit!
The good thing for us is that the price never breaks the middle moving average of the bollinger band, so we ignore all of the false signals from the stochastic oscillator.
After the 5 false signals, the stochastic provides another sell sign, but this time the price of Netflix breaks the middle moving average of the bolligner band.
We go short, holding the trade until the price touches the lower bollinger band.
If we compare the two trading methodologies, we realize that with the bollinger bands we totally neutralized all the false signals.
If we have a $10,000 bankroll with day trading leverage of 1:4, we have a buying power of $40,000. If we then invest 15% of our buying power in each trade ($6,000), below are the results:
First trade: 6,000 x 0.0042 = $25.20 profit.
Total bankroll: 10,000 + 25.20 = $10,025.20
Second trade: 6,015.12 x 0.0082 = $49.32 profit
Total bankroll: 10,025.2 + 49.32 = $10,074.52
Third trade: 6,044.71 x 0.0093 = $56.22 profit
Total bankroll: 10,074.52 + 56.22 = $10,130.74
Fourth trade: 6,078.44 x 0.0017 = $10.33 profit
Total bankroll: 10,130.74 + 10.33 = $10,141.07
We were able to generate $141.07 of profit with four scalp trades. Each of these trades took between 20 and 25 minutes.
While these trades had larger percentage gains due to the increased volatility in Netflix, the average scalp trade on a 5-minute chart will likely generate a profit between 0.2% to 0.3%.
As you can see, the stochastic oscillator and bollinger bands complement each other nicely. The stochastic oscillator says “get ready!” and the bollinger bands say “pull the trigger!”
Risk Management when Scalp Trading
We discussed a profitable scalp trading strategy with a relatively high win/loss ratio. We also suggested leveraging 15% of the buying power for each scalp trade. Now we need to explore the management of risk on each trade to your trading portfolio.
Since you are a scalp trader, you aim for lower returns per trade, while shooting for a higher win/loss ratio.
Therefore, your risk per trade should be small, hence your stop loss order should be close to your entry.
To this point, try not to risk more than .1% of your buying power on a trade.
Let’s see how a tight stop would impact the stochastic/bollinger bands scalp trading strategy.
This is the 2-minute chart of Oracle Corporation from Nov 24, 2015. There were three trades: two successful and one loser.
For the first trade, the stochastic crossed below the overbought area, while at the same time the price crossed below the middle moving average of the bollinger band.
We shorted Oracle at $39.06 per share, with a stop loss at $39.09, 0.1% above our entry price. The price began decreasing and 14 minutes later, ORCL hit the lower bollinger band. We exited the trade at 38.95, with a profit of 0.28%.
After hitting the lower bollinger band, the price started increasing. The stochastic lines crossed upwards out of the oversold area and the price crossed above the middle moving average of the bollinger band.
We went long on this signal at $39.04. Our stop loss is located at $39.00, 0.1% below the entry price. This trade proved to be a false signal and our stop loss of .1% was triggered 2 minutes after entering the trade.
The third and final signal took over 40 minutes to develop.
After the price crossed above the oversold territory and the price closed above the middle moving average, we opened a long position.
We entered the market at $38.97 per share with a stop loss at $38.93, 0.1% below our entry price.
This time Oracle increased and we closed a profitable trade 2 minutes after entering the market when the price hit the upper bollinger band, representing a 0.17% price increase.
So, if we had a $10,000 bankroll leveraged to $40,000 buying power, these are the results from a 15% investment per trade:
First Trade: 6,000 x .28% = $16.80 profit.
Total bankroll: 10,000 + 16.80 = $10,016.80
Second Trade: 6,010.08 x -0.1% = $6.01 loss
Total bankroll: 10,016.80 – 6.01 = $10,010.79
Third Trade: 6,006.47 x 0.17% = $10.21 profit
Total bankroll: 10,010.79 + 10.21 = $10,021
These three trades generated a profit equal to $21. The total time spent in each trade was 18 minutes.
Usually, when you scalp trade you will be involved in many trades during a trading session. Sometimes, scalp traders will trade more than 100 trades per session.
Scalp Trading and Commissions
I would be remised if I did not touch on the topic of commissions when scalp trading. If you look at our above trading results, what is the one thing that could completely expose our theory?
You guessed it right, commissions.
If you have a flat rate of even 5 dollars per trade, this would make the exercise of scalp trading pretty much worthless in our previous examples.
This is why when scalp trading, you need to have a considerable bankroll to account for the cost of doing business. You are going to find it extremely difficult to grow a small account scalp trading after factoring in commissions and the tax man at the end of the year.
The only thing you will end up doing after thousands of trades is lining your broker’s pocket.
- Scalp trading involves entering trades for a short period of time to catch swift price moves.
- When you scalp trade you:
- are less exposed to risk
- place many trades per day
- control your inner greed because you aim for small profits.
- If you scalp trade, you need a win/loss ratio greater than 50%.
- Oscillators could be very useful for your scalp trading system, because they are leading indicators; however, oscillators are not meant to be a standalone indicator.
- Try to find indicators that complement each other so you can validate trade signals.
- Scalp trading money management is crucial:
- Invest around 15% of your buying power in each scalp trade.
- Put a stop loss 0.1% from your entry price.
- Stay in the trades until the price hits the opposite bollinger band
- You will usually make between .2% and .3% per trade if you trade lower chart frames.
- If you scalp on higher chart time frames (5-minute, or more) you targets might be higher.
- You must have a solid bankroll to scalp trade. Small accounts will be eaten alive by trading commissions.