Moneyzine

What Is Scalping in Trading?

When done right, small gains can compound into a significant fortune. Discover the ins and outs of scalping and learn how this strategy works.
Hristina Nikolovska
Author: 
Hristina Nikolovska
Idil Woodall
Editor: 
Idil Woodall
11 mins
September 21st, 2023
Advertiser Disclosure

The investing term scalping refers to individuals that hold a large number of securities for a very short period of time with the hope of profiting from small movements in the price of the security. Scalpers will conduct these trades in common stocks, bonds, derivatives, commodities as well as foreign currency.

In this article, we talk about how scalping works, different strategies, and key considerations.

How Does Scalping Work?

Scalping can allude to three different trading techniques, two of which are legitimate and rely on speed, while the third relies on deception and is considered fraud. All three techniques allow the trader to profit from relatively small changes in the security price.

  • Bid-ask arbitrage – The first technique takes advantage of a security's bid-ask spread. The scalper purchases a large number of securities, and then quickly sells them back into the market. Trading in large volumes of securities can result in substantial profits, even with relatively small margins.

  • Momentum trading – The second technique takes advantage of a sudden increase or decrease in the price of a security. The scalper monitors the price of securities, looking for a “breakout” that might signal short-term volatility in the marketplace. Once identified, the scalper takes a large position in the security and then closes out before subsequent market corrections occur.

  • Pump and dump – The third technique involves a form of market manipulation. The scalper, oftentimes an investment advisor, purchases a security and recommends it to their clients. The increase in demand for the security results in an increase in price, allowing the scalper to profit by closing out their position in the security.

How is scalping different from swing trading?

Both scalping and swing trading are viable and popular short-term trading strategies. The main difference between the two lies in the duration of the positions held open. While the goal of a scalp trade strategy is to enter and exit trades within minutes or hours in a bid to accumulate profits, a swing trader holds positions for at least a few days until they meet their profit targets.

Advantages and Risks of Stock Scalping

Pros
  • Potential for quick profits
  • Opportunity to profit during narrow markets
  • Less capital intensive than other trading styles
  • Relies on short technical analysis rather than in-depth fundamental analysis
Cons
  • High trading costs
  • Riskier than some of the other trading styles
  • One bigger loss can potentially nullify all previous smaller gains
  • Small profits can make it challenging to reach financial goals

Scalping Trading Strategies

The fast-paced nature of scalp trading necessitates the use of technological tools and software to monitor market data, analyze price charts, and identify potential entry and exit points. These computer tools may include advanced trading platforms that provide real-time market data, customizable charts, and technical indicators.

Scalpers often utilize specialized indicators, such as moving averages, oscillators, or order flow analysis tools, to create their scalping strategies and identify potential trading opportunities.

Here are some of the most popular strategies used by scalp traders.

Scalping With Stochastics

Scalping with stochastics is a trading strategy that uses a tool called Stochastic oscillators to help identify when a security is overbought or oversold.

When a security's price has been rising for a while, it might reach a point where it becomes overbought, meaning it has gone up too much and could reverse its direction soon. Conversely, when a security's price has been falling, it might reach a point where it becomes oversold, indicating it has gone down too much and could bounce back.

The Stochastic oscillator is a tool that helps traders identify these overbought and oversold conditions.

It consists of two lines, %K and %D, which move up and down on a scale from 0 to 100. When the %K line crosses above the %D line, and both lines are in the overbought zone (above a certain value, like 80), it suggests that the security might reverse and start moving downwards. This could be an opportunity to sell the security and profit from a potential price decrease.

In contrast, when the %K line crosses below the %D line, and both lines are in the oversold zone (below a certain value, like 20), it suggests that the security might reverse and start moving upwards. This could be an opportunity to buy the security and profit from a potential price increase.

Scalpers using this strategy closely monitor the Stochastic lines and wait for these signals to occur so they know when to enter and exit trades to capture short-term price reversals.

Scalping With Moving Averages

Scalping with moving averages is a trading strategy that uses two lines on a price chart called moving averages to help scalpers identify potential buying and selling opportunities.

The shorter-term moving average represents the average price over a shorter period, like 5 days, while the longer-term moving average represents the average price over a longer period, like 20 days.

When the shorter-term moving average crosses above the longer-term moving average, it suggests that the price might continue rising, indicating a potential buying opportunity. This is because the shorter-term average shows the recent price movement is higher than the longer-term average, indicating upward momentum.

On the flip side, when the shorter-term moving average crosses below the longer-term moving average, it suggests that the price might continue falling, indicating a potential selling opportunity. This is because the shorter-term average shows the recent price movement is lower than the longer-term average, indicating downward momentum.

Scalpers using this strategy, monitor the crossing points of the moving averages and take quick actions based on those signals.

Price Action Scalping

Unlike the previous two, price action scalping is a strategy that relies solely on analyzing a security's price movement without using any indicators or oscillators. As such, it is a more discretionary approach to scalping and requires traders to develop a deep understanding of price patterns and dynamics of the financial markets.

Price action scalping involves closely observing the formation of candlestick patterns, chart patterns, and support and resistance levels to make trading decisions.

Common price action patterns
  • Reversal patterns indicate a potential reversal in the price direction. Examples include double tops/bottoms, head and shoulders, and bullish/bearish engulfing patterns.

  • Continuation patterns suggest that the current price trend is likely to continue. Examples include flags, pennants, and triangles.

  • Breakouts occur when the price moves beyond a significant support or resistance level. Scalpers may take advantage of breakouts to enter trades in the direction of the breakout.

  • Support and resistance levels are areas on the price chart where the price has historically found support (bouncing off the level) or resistance (reversing near the level). Scalpers pay close attention to these levels and may take trades based on price reactions at these levels.

Expert scalpers use these patterns to identify high-probability trading opportunities and make quick trading decisions. They rely on their ability to interpret price action and gauge market sentiment to enter and exit trades.

Scalping as a Primary vs Supplementary Trading Style

While many traders use scalping as a trading style, not everyone uses it as their primary approach. Only pure scalpers dedicate their trading efforts and strategies exclusively to short-term, quick trades, with little to no emphasis on longer-term positions or investment strategies.

On the other hand, many traders with longer time frames use scalping as a means to capture quick profits or mitigate risks within their overall trading strategy. Particularly in choppy markets, when price movements are limited, traders may utilize scalping as a supplementary trading style.

Additionally, some traders adopt an umbrella concept, which combines both longer-term trading strategies and scalping. The umbrella concept involves holding a core position based on a longer time frame analysis while using scalping to capitalize on short-term opportunities within that larger position.

Ultimately, scalping can be a versatile trading style that caters to different trading preferences and objectives. Skilled traders tailor their scalping techniques to suit their individual trading systems and enhance their overall trading performance.

Key Considerations for Scalping Stocks

Due to its need for precision in timing, quick decision-making, and the ability to manage transaction costs effectively, scalping is a challenging trading style, particularly for beginners.

However, some novice traders find the instant gratification aspect of picking a large number of small successful trades appealing and may be drawn to the potential for quick profits.

While mastering the art of scalping is going to take time, there are a few considerations that can help beginners get on the right track and instantly take their trading one level above.

Executing Orders

The very first thing a new scalper needs to master is to be as efficient as possible when executing orders. Since scalping is essentially trading with very thin profit margins, a single incorrect or delayed order can significantly impact their profitability, or even turn the profits into losses. To ensure precise order execution, beginners can utilize supporting systems like Direct Access Trading and Level 2 quotations.

Keeping Costs Low

All traders want to keep commissions and transaction costs at a minimum. However, scalping, which involves trading with slim profit margins and making numerous trades per session, places even greater emphasis on cost management. This is why newbie scalpers must do their best to find the right online broker that will give them the best commission rates while keeping in mind that not all brokers allow scalping.

Trend and Momentum Trading

Being able to spot and capitalize on trends and momentum is crucial for the success of inexperienced scalpers. Developing the skill to identify these patterns is essential for maximizing their profitability in the initial stages of their scalping career. The more experienced scalp traders also use countertrends to generate profits from reversals, but beginners need to master the basic techniques before moving on to the more advanced ones.

Trading Sides

Similarly to the previous point, beginner scalpers will achieve the best results if they develop their trading skills gradually when it comes to trading sides, as well. While scalping is flexible enough to allow traders to profit from both rising and falling prices, new scalpers can start by sticking to the buying side. When they build enough confidence in their trading, they can move on to long positions to balance their trades.

Technical Analysis

As we previously mentioned, technology plays a big role in many scalping strategies, and most scalpers use technical analysis tools to identify profitable opportunities. New scalpers need to become proficient in using specialized indicators to keep up with the competition. At the very least, they need to be able to use basic tools, like trend lines, support and resistance levels, and chart patterns, and base their strategies on technical analysis.

Finding the Right Market

Inexperienced scalpers may have doubts about finding a market suitable for their debut on the scaping scene. Because scalping is a strategy that relies on quick trades and capturing small price movements, high volume, and liquidity are the two most important factors to consider. They indicate that there are enough buyers on the market to allow easy entry and exit positions and ensure efficient order execution.

Closing Positions

Finally, all new scalpers need to understand the importance of closing positions during trading sessions and not get tempted to keep them overnight. By closing positions during the trading session, scalpers can mitigate the risks of overnight market fluctuations and unexpected news events. Beginners must remember that scalping is a trading style that requires incredible discipline to manage risk effectively and optimize profitability.

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FAQ

Is stock scalping illegal?
How risky is scalping?
How many trades per day do scalpers make?

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Contributors

Hristina Nikolovska
Hristina Nikolovska, a graduate of the University of Lodz, is a skilled finance writer for MoneyZine.com. With a knack for simplifying intricate financial topics, her articles provide readers with clear and actionable insights.
Idil Woodall
Idil is a writer with interests ranging from arts and politics to history and finance. She spent several years in publishing before becoming a full-time writer, and learning the inner workings of an industry she loved ignited her interest in economics. As an English graduate, she cultivated valuable research and storytelling abilities that she now applies to make complex matters accessible and understandable to many. When she’s not writing, she can be found climbing or watching a movie.
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